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  • Pricing options - an example

     
     

    The price for an option is based on three factors, the intrinsic value, the time to expiration (or time value), and the implied volatility. The cost of an option is related to how close the strike price is to the market price ruling at the time the option contract is concluded. As with futures there is an active trade in option contracts.

    • The strike price is the price quoted in an option; the price at which the option can be exercised.
    • The intrinsic value of an option is the strike price as a differential to where the market is trading. If this intrinsic value is negative then it is considered to be zero.
    • The time value of the option is also a factor in determining the premium. A longer time until expiration of the option increases the likelihood that the option will be exercised.

    Example

    If December futures are trading at 54 cts/lb then a December call with a 50 cts/lb strike price might be quoted at a 6.50 cts/lb premium. The intrinsic value then is 4 cts/lb because the option is in the money. But a December call with a strike price of 60 cts/lb might trade at a 3 cts/lb premium, meaning the intrinsic value is nil because the option is out of the money. Of course the buyer of an option has the choice of paying a higher premium to establish a greater level of price protection.

    'Out of the money' options will not usually be exercised.


    Implied volatility, which is based on a mathematical formula, evaluates the premium on the expected price volatility of the underlying futures contract. It is important to realize that the price of an option can change because of time and volatility factors even when the underlying futures price does not move.

    Option strategies
    are extremely diverse, and almost any strategy can be developed using options (obviously at a cost and a risk). A variety of names have been attributed to various strategies - strangles, condor, calendar spread, butterfly, and many others.

    The scope of option trading is vast and an explanation of all the strategies would take a book in itself. Call options are of little direct interest to producers and exporters. Selling or writing options is only for experienced hedgers and involves potentially unlimited risk. Both therefore fall outside the scope of this web site but more information can be obtained from both InterContinental Exchange and LIFFE.

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