Section 2: How to price commodity futures options
The most well known model for pricing options is the Black Scholes option model. Commodities futures option traders should have a grasp of this concept so as to appreciate the methods by which options are priced. The main functions of option pricing come down to time, volatility and market price.
The following is an example of the options for the S&P over the next three months.
These prices were made up in order to show you the relationship between time and volatility. Notice that the right to buy the market this month at or near the current price has a value of 20 but the next month out is going for 40 and the March contract is worth 60. This demonstrates how the value of an option will be greater if it has a longer life span. Because so much more can happen over 3 months than over a few weeks, the time value of an option will increase or decrease in proportion to its life span.
There will also be a greater premium paid for a lower strike price. The lower strike price means that the market doesn't have to move as far to go in the money and pay off for the owner so they will have a greater value than one the requires a larger move to 'pay off'.
Now that you can see how an options value is directly related to the strike price, the market price and the amount of time left, its easy to imagine how volatility works in. If a market is more volatile it will have a larger probability of making a move above a certain strike price. The Volatility index is a popular measurement of the volatility for the overall stock market and it has a historic range of between 8 and 28%. The higher the number is, the more volatile the market is. When it reaches historic lows the market is not moving much so the probability of a given option going in the money decreases. More volatile markets will demand greater premium for insurance against large price swings.
Black Scholes does a great job of incorporating these three elements into a formula that is used by a wide range of option traders on a daily basis. A detailed analysis of Black Scholes is beyond the scope of this site but a detailed analysis can be found on wikipedia.org
Futures-Option-Trading.com
1: Futures option trading basics
2: How to price futures options
3: Understanding the Greeks
4: Using option spreads
5: Synthetic options and futures
6: Strategies
7: Tips for buying and selling
8: Risk Disclosures for options
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