As we discussed yesterday in The Layman's Guide to Natural Gas Options - Part I, there are four primary variables that affect the premium or price of natural gas, as well as other energy commodity, options.

• The prevailing price of the underlying natural gas swap relative to the strike price of the option
• The time remaining until the option expires (also known as theta)
• Price volatility of natural gas swap
• Interest rates

Yesterday we focused on the first variable, the prevailing market price vs. the strike price of the option. Today we're going to address another major component of the option premium or price, the time remaining until the options expires, also known as time value or theta. The time value of an option is the value (price) that traders place on the option above the option's intrinsic value. Premiums on out-of-the-money options are, all else being equal, valued based on time to expiration since their intrinsic value is zero, as are at-the-money options. As options become significantly in- or out-of-the-money, the premium attributed to time value declines substantially.

The premium attributed to time value for in-the-money options is the value (amount) that exceeds the options' intrinsic value and reflects the possibility that the option may move deeper into-the-money. The time value of an option declines as the date of expiration approaches. The reason is that there is less and less time for a major change in market behavior, and a decreasing likelihood that an option will increase in value as the time to expiration approaches.

In summary, if you were to compare two natural gas options which have the same underlying, strike price, volatility and interest rate, but with different expiration dates, one expiring in six months and one expiring in one month, the option with six months to expiration would trade at a premium (higher price) to the option with one month to expiration.

To expand, if you are a natural gas producer or consumer looking at hedging natural gas by purchasing put or call options, respectively, the longer the tenor (time until expiration) of the option, all else being equal, the higher the cost of the option.

In our next post we'll explain the role of volatility in determining 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 I - Price

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

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