Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers. Three major variables influence the premium for a given option:
The option’s exercise price, or more specifically, the relationship between the exercise price and the current price of the underlying futures contract. All else being equal, an option that is already worthwhile to exercise (known as an “in-the-money” option) commands a higher premium than an option 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 valuable than a put option that conveys the right to sell gold at only $280 an ounce.
The length of time remaining until expiration. All else being equal, an option with a long period of time remaining until expiration commands a higher premium than an option with a short period of time remaining 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 contract. 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.
Reprinted with permission from the National Futures Association. Copyright 2002.