Session 1, Lesson 4 / Understanding Premiums

The amount of money that the buyer of the option pays to the seller, in exchange for being granted certain rights, but no obligations, is called premium. Simply put, premium is what you pay for an option.

Ultimately, the amount of premium paid is negotiated between the buyer and the seller. As an example, a trader who expects lower prices buys a December $2.50 corn put would instruct his broker that he is willing to pay a certain premium for the option. The broker transmits the order to his representative on the floor of the exchange who then attempts to find a broker willing to sell that same put option for that price or less. If a trader was trying to buy for a price less what a seller would be willing to sell the option for, no transaction would take place.

While, ultimately, the price is negotiated between the buyer and the seller, there must be a way at arriving at what could be called a fair market value for that option. If you attended an auction where equipment would be sold, you could probably guess ahead of time within a certain range what various equipment should sell for. Equipment has a certain fair market value based on age, condition and any number of other factors. As the buyer, you’re always trying to buy as low as possible to save yourself money, and the seller is always hoping to sell for as much as possible. The same is true in the case of options. As the buyer, you’re always hoping to buy the option for as little as possible, while the seller tries to get as much as possible to justify the risk that he is taking.

A misconception is that the premiums are set by the exchange. That is not correct. The premium is arrived at through a system of open outcry between buyers and sellers. But, just as in the case of equipment, you can also arrive at a fair market value for an option. Just as at a auction, the piece of equipment may sell above or below the fair market value, the same is true with an option on soybeans or any other product. The premium may end up being a bit low and be a better deal for the buyer, or it may end up a little bit high and benefit the seller. In either case, the premium is unlikely to vary significantly away from the fair market value.

So how is the fair market value arrived at? The value of an option can be broken down into two major components — time value and cash (intrinsic) value. Cash value is the easiest to determine, so let’s look at that first. I like to describe the cash value as being the amount of money you would receive if you “cashed in” the option today. In the case of a put option, we said that the buyer of the put has the right, but not the obligation, to turn that option into a futures contract at the strike price at anytime they wish.

Example: Assume March corn futures are at $2.22 per bushel. A $2.30 put is listed for 10-1/2 cents. We now know that this premium is made up of cash value and time value, though one or the other of those values can be equal to zero. To determine the cash value, ask yourself the question, “How much would that option be worth if I cashed it in today?” If you cashed in a $2.30 Mar corn put (had your broker convert it into a short position in Mar futures at $2.30 -this is called exercising), you would find a cash value of 8 cents when Mar futures are $2.22. In the case of a put, simply take the put strike price (in this example $2.30) and subtract the current futures price (in this example $2.22) to arrive at the cash value (in this case 8 cents). Of the 10-1/2 cent premium for that option, you now know that you have 8 cents in cash value and the remainder is always time value (in this case 2-1/2 cents).

Let’s take a quick look at a call option example. Assume Jan feeder cattle futures are at $83. If a Jan. $82 call option is listed at $1.90, what would the cash and intrinsic value be? Since a call option gives you the right to be long the futures, if we were to exercise or convert that option to a futures position, we would be long Jan futures at $82. Since Jan futures are at $83.00, we would have a cash value of $1.00. Subtracting $1.00 from our premium of $1.90 leaves us a time value of $.90.

Since cash value is a matter of math arrived at by comparing the strike price with the current futures price, the real variable in the premium lies in the time value. Time value is affected by four factors: The amount of time left until expiration, the volatility of the futures, how close the option is to the current futures prices and short term interest rates.

The amount of time left until expiration is easy to understand. If we go back to our example of insurance, you could simply ask, “Which would cost me more — three months of car insurance or six months?” The same is true with ag options. A June put option is going to cost you more than an April put option simply because you’re buying coverage for a longer period of time. As you get closer and closer to the expiration of the option, the amount of time value attributed to this factor becomes less and less. This is sometimes referred to as the decay factor.

A second factor in determining the amount of time value is the volatility of the underlying futures. The more volatile the futures are, the more erratically they’re moving up and down, the more expensive the option will be. Yet another factor influencing the time value is the proximity of the option strike price to the futures. For now, let me just say that the closer an option is to the futures price, the more time value you will pay. The fourth and least significant factor is the short term interest rate. Since speculators look at selling options as a form of investment, they must compare the potential returns to those of other investments. In general, lower interest rates correlate to lower option premiums, but don’t expect to see it reflected in any significant way.

ASSIGNMENT

1. Use the following table to complete exercise 2 below.

Futures Price = Mar corn $2.26-1/2 / Jan soybeans 5.68 / Mar Chicago wheat 3.74-1/2 / Feb live hogs 44.25

Feb live cattle 73.87 / Jan feeder cattle 83.57

2. Fill in the spaces below using the futures prices listed above.

Cash value Time value Total Prem

(a) (b) (a & b)

Mar 240 corn put ———— ———— ————

Jan 575 bean put ———— ———— ————

Mar 360 wheat put ———— ———— ————

Feb 44 live hog put ———— ———— ————

Feb 72 live cattle put ———— ———— ————

Jan 82 feeder cattle call ———— ———— ————

SUMMARY

— Premium is the term used to describe the amount of money paid by the buyer to the seller in an options contract. — The premium is negotiated between the buyer and the seller with contracts traded in a trading pit on the floor of the exchange. — Premium can, and often does, change throughout the day based on changes in market conditions. — Premium can be broken down into two major parts: cash value and time value. — The cash value of an option is determined mathematically. — The time value of an option is determined primarily by four factors: the amount of time remaining until expiration of the option, the volatility of the underlying futures contract, the proximity of the option strike price to the futures price, and short term interest rate.