The Arithmetic of Option Premiums
At the time you purchase a particular option, its premium cost may be $1,000. A month or so later, the same option may be worth only $800 or $700 or $600. Or it could be worth $1,200 or $1,300 or $1,400. Since an option is something that most people buy with the intention of eventually liquidating (hopefully at a higher price), it’s important to have at least a basic understanding of the major factors which influence the premium for a particular option at a particular time. There are two, known as intrinsic value and time value. The premium is the sum of these.
Premium = Intrinsic Value + Time Value
Intrinsic Value
Intrinsic value is the amount of money, if any, that could currently be realized by exercising the option at its strike price and liquidating the acquired futures position at the present price of the futures contract.
At a time when a U.S. Treasury bond futures contract is trading at a price of 120-00, a call option conveying the right to purchase the futures contract at a below-the-market strike price of 115-00 would have an intrinsic value of $5,000.
As discussed on page 8, an option that currently has intrinsic value is said to be "in-the-money" (by the amount of its intrinsic value). An option that does not currently have intrinsic value is said to be "out-of-the-money."
At a time when a U.S. Treasury bond futures contract is trading at 120-00, a calloption with a strike price of 123-00 would be "out-of-the-money" by $3,000.
Time Value
Options also have time value. In fact, if a given option has no intrinsic value—because it is currently "out-of-the-money"—its premium will consist entirely of time value.
What's "Time Value?"
It’s the sum of money option buyers are presently willing to pay (and option sellers are willing to accept)—over and above any intrinsic value the option may have—for the specific rights that a given option conveys. It reflects, in effect, a consensus opinion as to the likelihood of the option’s increasing in value prior to its expiration.
The three principal factors that affect an option’s time value are:
1. Time remaining until expiration. Time value declines as the option approaches expiration. At expiration, it will no longer have any time value. (This is why an option is said to be a wasting asset.)
2. Relationship between the option strike price and the current price of the underlying futures contract. The further an option is removed from being worthwhile to exercise—the further "out-of-the-money" it is—the less time value it is likely to have.
3. Volatility. The more volatile a market is, the more likely it is that a price change may eventually make the option worthwhile to exercise. Thus, the option’s time value and therefore premium are generally higher in volatile markets.
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