Option Premium Valuation

The price (value) of an option premium is determined competitively by open outcry auction on the trading floor of the CBOT. 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.

Prices for T-bond and T-note futures contracts are quoted differently from the options premiums on these futures. Options on these contracts are quoted in 64th of a point. Therefore, a quote of -01 in options means 1/64, in futures, 1/32.

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, in December, a June Treasury bond futures contract is priced at 82-00, while the June 80 call is priced at 3 10/64. The intrinsic value of the option is 2-00:

Bond futures              82-00
Option strike price      80-00
Intrinsic value            2-00

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 = 3 10/64 - 2-00 = 1 10/64

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.

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 same is true with options on interest rate futures-the longer the term until expiration, and the more volatile the underlying market, the greater the option premium.

Source: National Futures Association

Please note: "Education Center" is a treasure trove of highly informative information designed to teach beginners about and how to trade the futures markets. However, before you begin trading on your own, we strongly advise you to first trade with the assistance of an experienced professional commodity broker. A broker can provide you with many valuable functions to suit your choice. You may only want to have a broker try to make sure you don’t make costly errors by incorrectly initiating and exiting a trade (a common error among beginning traders). On the other hand, you may want the broker to take a more active role: acting as a sounding board for your trades, providing his trading recommendations, research reports, charts, and other helpful trading tools. Or, you may want the broker to find you a commodity trading advisor that best meets your investment goals, affordability, and suitability to professionally manage your account.

Whatever your needs are, a Bright Commodity Broker is a trained professional, there to help and provide you the level of service that you want.