Kenneth R. Szulczyk
Amount paid for an option premium depends on the probability the buyer of the option will
exercise his right. Thus, options contracts are insurance. For example, a driver with a history of
car accidents usually haves a greater probability of having future accidents. Hence, this driver
pays a greater premium for his car insurance company.
We list five factors that influence an option premium:
If the spot market price rises, subsequently, the option's premium for a European call
option increases while the premium decreases for the put option. Remember, the option
holders would exercise an option if they can buy low and sell high. Investor would more
likely exercise the call option to buy at the strike price and sell at the spot price. Put option
is the opposite. If the strike price increases, then the option's premium for a European call option decreases
while the premium increases for a put option. Investor would not exercise the call option if
the strike price exceeds the spot price. Otherwise, he would buy high and sell low. On the
other hand, an investor would exercise a put option if the strike price exceeds the spot
price. He or she buys low using the spot price to sell to the option holder using the strike
price. If a commodity's price is highly volatile, subsequently, the commodity's price fluctuates
greatly, and an option holder is likely to exercise both the call and put options.
Consequently, the option issuer charges a greater option premium for both calls and puts.
For example, the market price of Asset A fluctuates between $20 and $100 while Asset B
fluctuates between $60 and $70. Therefore, the option premium for Asset A is greater
because the large swings in the price boosts the likelihood the investor exercises the option. An option with a longer time maturity has a greater option premium. For example, Option
A has a maturity of one year while Option B has a maturity of one month. Thus, Option A
has a larger option premium because investors experience more uncertainty in its asset’s
prices. Dramatic events could happen during the year that ensures the investors exercise the
option. Interest rates affect options just like bonds and stock. A higher interest rate reduces the
present value of the option, increasing the value of the call option and decreasing the value
of the put option.Example 1: Strike price for petroleum is $80 per barrel, and the European's option premium
equals $0.1 per barrel with an option size of 10,000 barrels. A company buys 10 call options
with a total quantity of petroleum of 100,000 barrels. Thus, the company pays
$0.1 10 , 000 10 =$ 10 , 000 for the premium.
Two scenarios occur with an options contract:
Scenario 1: If the spot market price exceeds the $80 strike price, then the company
exercises the call options. Company buys petroleum at $80 and resells the petroleum on the spot