the time value of the option. The time value reflects the possibility that
exercise will become more profitable if the futures price moves farther
away from the strike price. Generally, the more time until expiration, the
greater the time value of the option because the likelihood of the option
becoming profitable to exercise is greater. At expiration, the time value is
zero and the option price equals the intrinsic value.
Volatility
The degree of fluctuation in the price of the underlying futures contract is
known as “volatility” (see Appendix B, Resources, for the formula). The
greater the volatility of the futures, the higher the option premium. The
price of a futures option is a function of the futures price, the strike price,
the time left to expiration, the money market rate, and the volatility of the
futures price. Of these variables, volatility is the only one that cannot be
observed directly. Considering all the other variables are known, however, it
is possible to infer from option prices an estimate of how the market is
gauging volatility. This estimate is called the “implied volatility” of the
option. It measures the market's average expectation of what the volatility
of the underlying futures return will be until the expiration of the option.
Implied volatility is usually expressed in annualized terms. The significance
and use of implied volatility is potentially complex and confusing for the
general investor, professionals having a decided edge in this area. Their
edge can be removed by serious study.
Exercising the option
At expiration, the rules of optimal exercise are clear. The call owner should
exercise the option if the strike price is less than the underlying futures
price. The value of the exercised call is the difference between the futures
price and the strike price. Conversely, the put owner should exercise the
option if the strike price is greater than the futures price. The value of the
exercised put is the difference between the strike price and the futures price.
To illustrate, if the price of the expiring futures contract is 7,600, a call
struck at 7,500 should be exercised, but a put at the same or lower strike
price should not. The value of the exercised call is $1,000. The value of the