This post is the second in a series on crude oil options.  This first post in the series can be found via the following link: A Beginner's Guide to Crude Oil Options - Part I.  As mentioned in the previous post, there are four primary variables that affect the premium or price of crude oil options (as well as options on other energy commodities):

• Prevailing price of the underlying future or swap relative to the strike price of the option
• Time value (also know as tenor or duration)
• Volatility
• Interest rates  

In the last post, we focused on the first variable, the prevailing market price (the underlying crude oil future or swap) vs. the strike price of the option. Today we're going to address another major component of crude oil option prices, the time remaining until the option expires, also known as time value, tenor, duration or more specifically, theta.  Why so many different terms? Time value is the "layman's" term, tenor is the term most commonly used in the commodity trading world, duration is the term used in the fixed income world and theta is the term used to describe time value specifically as it relates to mathematical formulas used to determine the value of options.  The time value of an option is the value (price) that traders place on the option above the option's intrinsic value.  So if we know the value of an option and we subtract the intrinsic value, we also know the time value of the option.  

The value of 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 significantly out-of-the-money, the premium attributed to time value declines substantially.

More specifically, the value 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 option approaches the date of expiration. The reason this is the case is that shorter the life of an option, the lower the probability that market prices, in this case crude oil, will change significantly. Given that this is the case, as the time to expiration approaches, there is a decreasing likelihood that an option will increase in value.

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

As an example, consider the case of two Brent crude oil options, both with a strike price of $102.50/BBL, an underlying of $102.50/BBL, a volatility of 21% and an interest rate of 0.28% but with different expiration dates, one in 26 days (July expiration) and another in 57 days (August expiration).   All else being equal, the July option would be valued at approximately $2.35/BBL while the August option would be valued at approximately $3.45/BBL

To expand, if you are a crude oil consumer, refiner, marketer or producer looking to hedge your exposure to crude oil prices by purchasing options, 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 crude oil options.

UPDATE: This post is the second in a series on crude oil options.  The previous and subsequent posts can be found via the following link:

A Beginner's Guide to Crude Oil Options - Part I - Strike Price

A Beginner's Guide to Crude Oil Options - Part III - Volatility

A Beginner's Guide to Crude Oil Options - Part IV - Interest Rates