The Premium Vanilla Option

TIntrinsic Value: It is important to acknowledge that an option premium has intrinsic value and time value. At expiry, the intrinsic value is simply the difference between the strike (the predefined rate) and the spot (the current rate).

Time Value: This is the difference between the option premium and the intrinsic value of the option.Even if the option may have a positive intrinsic value, as there may be a still a long time until expiry, intrinsic value may be overshadowed by time value. If a trader opens an option contract with a long time horizon, the premium will be higher as there are larger possibilities of the option expiring favourably. As time to expiry decreases, then time value slowly diminishes.

Money-ness

In the Money: when an option contract has intrinsic value.
◾◾ A Call option is in the money when the strike price is below the current spot price of the underlying currency pair.
◾◾ A Put option is in the money when the strike price is above the current market price of the underlying currency pair.
At the Money: when an option contract has no intrinsic value. Call or Put options are at the money
when the strike price is the same as the current market price.
Out of the Money: when an option contract has no intrinsic value.
◾◾ A Call option is out of the money when the strike price is above the current market price of the underlying currency pair.
◾◾ A Put option is out of the money when the strike price is below the current market price of the underlying currency pair.

How to price an option
The premium of an option is determined by a number of factors: the current exchange rate of the underlying currency pair, the interest rates of the currencies involved, the volatility the currency pair exhibits, the strike price and the amount of time until expiration. A change in these parameters will change the premium of the option.

Now let’s look at some definitions of the factors mentioned above:

Expiration Date: This is the date, predetermined by the trader, at which an option contract expires. With the easy-forex options platform you can open or close an option position at any time before the expiration date of the option. A longer expiration date means there is more time for the exchange rate to move in either direction and in which time the option may come to profit. Therefore a longer expiration will have a higher premium.

Strike Price: This is the price, predetermined by the trader, where the pair will be bought (in a call) and sold (in a put).

Volatility: This is an important concept to grasp when trading options but it is not that difficult. Let’s say that the EURUSD is trading around 1.3550 and the high and low yesterday were 1.3540 and 1.3560. Now suppose today it is still trading at 1.3550 but it traded as far up as 1.3570 and as low as 1.3530. The range within which this currency pair moves has widened and thus its volatility today, compared to that of yesterday, has risen.

The bigger the variation in the fluctuation of an exchange rate, the higher its volatility will be.The higher the volatility, the higher the option premium will be. That is because the underlying currency pair is likely to move a lot in either direction. Volatility itself is measured in standard deviations depicted by the Greek letter sigma (σ).

Take a look at the two graphs below to get a feel of volatility.
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