We're often asked to explain what determines the price of a natural gas (as well as crude oil, heating oil, gasoline, etc) option.  In short, in return for rights without obligations, options buyers pay (and options sellers receive) a premium.  For the sake of this explanation, we'll use natural gas swaps and options an an example.

The four major factors affecting the premium, or price, of natural gas options are:

• The prevailing price of the underlying natural gas swap relative to the strike price of the option
• The time remaining until the option expires
• Price volatility of underlying natural gas swap
• Interest rates  

The most significant influcence on the price of an option is the relationship between the price of the underlying natural gas swap price and the strike price of the option.  Depending upon the price of the underlying swap relative to a given strike price, an option is said to be at-the-money, in-the-money, or out-of-the-money.

An option is at-the-money when the strike price equals or is very close to the price of the underlying natural gas swap.  An option is considered in-the-money when the price of the underlying swap is above a call's strike price, or when the price of the underlying swap is below a put's strike price.

A put option is out-of-the-money when the underlying swap price is greater than the strike price of the option.  For example, if the October 2010 NYMEX look-a-like natural gas swap is currently trading at $5.00/MMbtu, the October 2010 NYMEX look-a-like $4.50 natural gas put option, which grants the holder of the option the right to sell October 2010 natural gas swap at $4.50/MMbtu, it is clearly-out-of-the-money.

Conversely, a call option is out-of-the-money when the underlying natural gas swap is less than the strike price of the option.  

The premium, or price, or an option will almost always equal or exceed the instrinsic value of the option, if any.  Intrinsic value is the amount by which options are in-the-money.

In our next post we'll explain how the time remaining until an option expires (theta, as it's known in finance) determines the value of the option.

UPDATE: This post is the first in a series on natural gas options.  The subsequent posts can be found via the following links:

The Layman's Guide to Natural Gas Options - Part II - Time Value

The Layman's Guide to Natural Gas Options-Part III - Volatility

The Layman's Guide to Natural Gas Options - Part IV - Interest Rates