Options Series Part 2

Premium & Strike Price

When you decide that you want to buy an option, there are several questions you’ll want to have answered.  The first one usually is “how much is it going to cost?”  The answer (the amount of money) is called the premium.  Premiums vary because of several different factors.  Since you’re buying time when you buy an option, the first ingredient in premium, or price, is the amount of time you want to purchase. The longer your option will last, the more expensive it will be. Most of us are tempted at the time of purchase to skimp on time in order to save a few dollars. Except in rare circumstances, you should opt for the higher priced, longer term option. As in every other economic venture, you get what you pay for.  A most frustrating trading experience is to call the market correctly only to run out of time before the big move.   

Since options in commodities are standardized, you will only be allowed to buy or sell at predetermined price levels. Those price levels are called Strike Prices. The cost of the strike price is determined by how far it is in or out of the money.  In the money refers to a call option with a strike price below the current market or a put option with a strike price above the current market quote. The premium consists of two parts - intrinsic value and time value.  Intrinsic value is the portion of the premium that is represented by real market value (the amount that it’s in-the-money).  Time value is the portion of the premium that is represented by the amount of time left until the option’s expiration.

As an option moves into the money it begins to exchange time value for intrinsic value. This value substitution keeps the option from appreciating at a rate equal to the underlying futures market. At-the-money would indicate that the current market and the strike price are the same. When the option is at the money it appreciates at about 50% of the rate of the underlying futures contract. As the market moves positively into the money, the option appreciates at a higher rate. Eventually, the intrinsic value replaces all of the time value and the option and futures appreciate and depreciate at the same rate. Obviously the opposite is true if the market moves negatively away from the strike price.