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Introduction to Options

This course is reproduced with the permission of XPRESSTRADE

Option Valuation

The price (value) of an option premium is determined competitively by open-outcry auction on the trading floor of the exchange. The premium is affected by the influx of buy and sell orders reaching the exchange floor. An option buyer pays the premium in cash to the option seller. This cash payment is credited to the seller's account.

The option premium has two components: "Intrinsic value" and "time value." The intrinsic value is the gross profit that would be realized upon immediate exercise of the option. In other words, intrinsic value is the amount by which the portion is in-the-money (an option that is out-of-the- money or at-the-money has no intrinsic value).

For example, let's suppose that in late January, the August Soybean futures contract is priced at 530.00, while the August 520 call is priced at 40.00. The intrinsic value of the option is therefore 10.00, or 10 cents.

Soybean Futures: 530.00
Call Strike Price: 520
Intrinsic Value: 10.00, which amounts to $500 (the Soybean contract is 5,000 bushels)

Time value reflects the probability the option will gain in intrinsic value or become profitable to exercise before it expires. Time value is determined by subtracting intrinsic value from the option premium: Time value = Option premium - Intrinsic value

= 40.00 less 10.00
= 30.00, or 30 cents, which amounts to $1,500

Several other factors also have an impact on the premium. One is the relationship between the underlying futures price and strike price. The more an option is in-the-money, the more it is worth. A second factor is volatility. Volatile prices of the underlying commodity can stimulate option demand, enhancing the premium. The greater the volatility, the greater the chance the option premium will increase in value and the option will be exercised; thus, buyers pay more while writers demand higher premiums.

A third factor affecting the premium is time until expiration. Since the underlying value of the futures contract changes more within a longer time period, option premiums are subject to greater fluctuation. An option with a long time until expiration will have more time value than an option with a short time remaining until expiration.

Some parallels can be drawn between the time value component of an option premium and the premium charged for an automobile insurance policy. The longer the term of the policy, the greater the probability a claim will be made by the policyholder. This, of course, presents a greater risk to the insurance company. To compensate for this increased risk, the insurer charges a greater premium. For example, the total dollar cost of a one-year policy to insure the vehicle will be greater than a six-month policy since the vehicle is being insured for twice as long - the likelihood of "something" happening within a year is greater than the likelihood of something happening within six months. The same is true with options -- the longer the term until expiration, and the more volatile the underlying market, the greater the option premium.

Next chapter: Conclusion

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