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Introduction to Options

This course is reproduced with the permission of XPRESSTRADE Back to Trading 101 Index

How Option Premiums Are Determined

Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers in the marketplace. Three major variables influence the premium for a given option:

•  The option's exercise price, or, more specifically, the relationship between the exercise price and the current price of the underlying futures contract. All else being equal, an option that is already worthwhile to exercise (known as an "in-the-money" option) commands a higher premium than an option that is not yet worthwhile to exercise (an "out-of-the-money" option). For example, if a Gold contract is currently selling at $430 an ounce, a put option conveying the right to sell Gold at $450 an ounce -- higher than the current futures price -- is more valuable than a put option that conveys the right to sell Gold at only $400 an ounce. Similarly, with Live Cattle futures currently trading at 86.00, an 84 call option is more valuable than an 88 call, because the 84 call allows you to buy futures below the existing market price.

•  The length of time remaining until expiration. All else being equal, an option with a long period of time remaining until expiration commands a higher premium than an option with a short period of time remaining until expiration. Why? Because the option with more time until expiration has more time in which to become profitable. Said another way, an option is an eroding, or "wasting" asset; its time value declines as it approaches expiration.

The volatility of the underlying futures contract. All else being equal, the greater the volatility, the higher the option premium. This is logical, because in a volatile market, the option stands a greater chance of becoming profitable to exercise.

Next chapter: Selling Options

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