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