Chapter 28: How Option Premiums are Determined

Option premiums are determined the same way futures prices are determined, through ac-tive competition between buyers and sellers. Three major variables influence the premium for a given option.

The option’s exercise price, or more specifi-cally, the relationship between the exercise price and the current price of the underly-ing futures contract. All else being equal, an option that is already worthwhile to exer-cise (known as an “in-the-money” option) commands a higher premium than an op-tion that is not yet worthwhile to exercise (an “out-of-the-money” option). For example, if a gold contract is currently selling at $290 an ounce, a put option conveying the right to sell gold at $310 an ounce is more valu-able than a put option that conveys the right to sell gold at only $280 an ounce.

The length of time remaining until expira-tion. All else being equal, an option with a long period of time remaining until expira-tion commands a higher premium than an option with a short period of time remain-ing until expiration because it has more time in which to become profitable. Said another way, an option is an eroding asset; its time value declines as it approaches expiration.

The volatility of the underlying futures con-tract. All else being equal, the greater the volatility the higher the option premium. In a volatile market, the option stands a greater chance of becoming profitable.