Option valuation is not as
straightforward as futures valuation. Option premium is comprised of intrinsic value and extrinsic value.
An option has intrinsic value if the market is trading above the strike price
of a call option, or below the strike price of a put option. If an option contract has intrinsic value it is called “in
the money.” If an option contract does not have intrinsic value it is called “out of the money.”
For example:
If
oats is trading at $3.50, a $3.20 call option is $.30 in the money so the intrinsic value of the option is $1,500.
The extrinsic value of the option is its “time value.” Extrinsic
value takes into account the possibility that an option may go in the money by expiration. The more time that an option has
the more extrinsic value it has. As an option approaches its expiration date, it looses value. This is called time decay.
At expiration an option has no extrinsic value so if the option is out of the money it expires worthless.
Oats option prices do not move in tandem with futures prices. A $.01 move in
your favor in the oats futures markets does not necessarily equal to a $.01 increase in the oats option value. The amount
that a option value will increase based upon an increase in its futures price is called its delta. Call option deltas are
measures from 0 to 1. As a option goes from “out of the money” to “in the money” its delta increases.
For example:
If
an oats call option has a delta of .5 and the price of the oats futures market increases by $.01 the value of the option will
increase by $.005 or $25.
