What determines the pricing of an option?

:::::>The price of the underlying future
:::::>The strike price of the option
:::::>The time remaining until the option expires
:::::>The volatility of the underlying future

The difference in the price of the underlying future to the strike price of the option determine the option's intrinsic value. The time remaining until expiration and the volatility of the underlying future determine the option's time value. Time value and intrinsic value together determine option price.

Intrinsic Value + Time Value = Option Price

The most important influence on an options price is the price of the underlying future. For example, if a futures market is trading 95 on expiration, a 100 call expires worthless. On the other hand, a 90 call is worth at least 5 points. The closer the option gets to expiration, the faster it decays. The rate of decay is related to the square root of the time remaining. An option with two months remaining decays at twice the speed of an option with four months remaining.

Definitions

:::::>At-the-Money
At the money describes where an option is trading in relation to the price of the underlying security. If ABC is trading at 100, a April 100 call is considered to be trading 'at-the-money'. If ABC is trading at 100, a April 100 put is 'at-the-money'.

:::::>In-the-Money
In the money describes where an option is trading in relation to the price of the underlying security­a call option whose strike is lower than the underlying price, or a put option whose strike is higher than the underlying price. If ABC is trading at 102, the April 100 call is considered 'in-the-money'. If ABC is trading at 102, the April 104 put is 'in-the-money.

:::::>Out-of-the-Money
Out of the money describes where an option is trading in relation to the price of the underlying security. It is an option which has no intrinsic value­for calls, an option whose exercise price is above the underlying future, for puts, an option whose exercise price is below the underlying future. If ABC is trading at 102, the April 100 put is 'out-of-the-money.' If ABC is trading at 102, the April 104 call is considered 'out-of-the-money.'

:::::>Intrinsic Value
The price difference between the underlying security and the option's strike price. An option must be in-the-money to have intrinsic value. For example, the price of a April 100 call: If ABC is trading at 102, and the call option is priced at 2 and the intrinsic value is 2. If ABC is trading at 99, the April 100 call has no intrinsic value. The converse is true for an April 100 put; if ABC is trading at 99, the 100 put is priced at 1.

:::::>Time Value
Time value is the premium amount by which the price of the option exceeds its intrinsic value. The time value premium of an option declines as expiration approaches. For example, the April 100 call, with ABC trading at 102, might sell for 5. That means the premium includes 2 points in intrinsic value and 3 points in time value. If ABC were trading at 99, and the premium is 2, there is no intrinsic value but 2 points in time value.

:::::>Theoretical Value
The value of an option generated by a mathematical model using certain assumptions about the term of the option, the characteristics of the underlying futures contract, and prevailing interest rates.

:::::>Volatility
Volatility is a measure of the range the underlying future is expected to fluctuate over time. Volatility is measured by the standard deviation of the daily price changes in the future. The more volatile the future, the greater the price of the option.

:::::>Historical volatility
Historical volatility estimates volatility based on past prices.

:::::>Implied volatility
Implied volatility starts with the current option price and works backward to determine the theoretical value of volatility equal to the market price minus any intrinsic value. Implied volatility is a measurement of the market's expected price range of the underlying commodity futures based on market-traded options premiums.

:::::>Delta
The amount by which the price of an option changes for every dollar move in the underlying instrument. Delta represents the ratio of the change in the theoretical value over the change in the underlyimg price.

:::::>Gamma
Gamma is the amount delta changes when the underlying price changes by one unit. It is the degree by which delta changes with respect to changes in the underlying price.

:::::>Theta
Theta measures the time decay of a position­it represents the amount that the theoretical value changes in one day if there is no change in the underlying price.

:::::>Vega
Vega is the amount that the theoretical value changes when the volatility changes by 1%.

:::::>Zeta
The percentage change in an options price per 1% change in implied volatility.

:::::>Rho
The change in theoretical value with respect to a change in the interest rate.

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