Option Contracts : Option Contracts Option contracts give the buyer the right (but not the obligation) to take a futures position at a certain price.
There are two types of options:
(1) Call Options give the buyer the right to go long a futures contract.
(2) Put Options give the buyer the right to go short a futures contract.
OPTION TERMINOLOGY : OPTION TERMINOLOGY Premium--the amount the option buyer pays the option seller for the option.
Strike Price--the price at which the buyer may obtain a short futures position (put) or long futures position (call).
Expiration Date--the month when the option expires. Most options expire one month ahead of the futures contract.
Exercise--when the option buyer converts the option to a futures position at the strike price. Can occur anytime prior to the option expiration date.
Option Strike Prices & Expiration : Option Strike Prices & Expiration Strike Prices are in fixed increments.
10 cents for Corn
10 cents for Wheat
25 cents for Soybeans
Option Expiration
Same contract months as Futures Contracts
Most options expire one month prior to the futures
The Short and Long of Options : The Short and Long of Options As with Futures Contracts, every Option Contract has a SHORT and LONG trader on each side.
Long (buy) position in the option
Buyer pays the premium to the seller; no margin required
Short (sell) position in the option
Seller receives the premium, posts margin funds
Example of Exercising a Call Option : Example of Exercising a Call Option Suppose a trader has a long 520 Dec call option. He can decide to exercise it anytime prior to expiration (around Nov 20).
Upon exercise, the trader is long Dec wheat a price of 520
Option seller must go short Dec wheat at a price of 520 to offset the long position delivered to the option buyer.
Example of Exercising a Put Option : Example of Exercising a Put Option Suppose a trader has a long 550 March put option. He can decide to exercise it anytime prior to expiration (around Feb 20).
Upon exercise, the trader is short March wheat at a price of 550.
Option seller must go long March wheat futures at a price of 550 to offset the short position delivered to the option buyer.
Option Premiums and Strike Prices... Some Intuition : Option Premiums and Strike Prices... Some Intuition With a call option...
You have the right to a long (buy) futures at the strike price.
As a buyer, you would prefer to buy at a lower price.
Lower strike price call options are always worth more than higher strike price calls.
Option Premiums and Strike Prices... Some Intuition : Option Premiums and Strike Prices... Some Intuition With a put option...
You have the right to go short (sell) futures at the strike price.
As a seller, you would prefer to sell at a higher price.
Higher strike price put options are always worth more than lower strike price puts.
OPTION PREMIUMS : OPTION PREMIUMS Option premiums consist of two components:
(1) Intrinsic Value (Cash-Out Value)
(2) Time Value
Option Premium = TV + IV
At expiration, Option Premium=IV
Intrinsic Value : Intrinsic Value The amount of money, if any, that could currently be realized by exercising an option with a given strike price.
What the option is worth at expiration.
For a Put:
Strike Price - Current Futures Price (if >0)
For a Call:
Current Futures Price - Strike Price (if >0)
Intrinsic Value: An Example : Intrinsic Value: An Example May Wheat Futures Price= 529
What is the Intrinsic Value for a:
Q: 510 Call Option?
A: 19 cents
Q: 540 Put Option?
A: 11 cents
Q: 540 Call Option?
A: 0 cents
Dec Put Option Premiums Dec Futures=550.25 : Dec Put Option Premiums Dec Futures=550.25 Strike Price Premium IV Residual
520 7.5 0 7.5
530 11 0 11
540 16 0 16
550 21.5 0 21.5
560 27 9.75 17.25
570 33.75 19.75 14
OPTION PREMIUMS Time Value : OPTION PREMIUMS Time Value Factors Influencing Time Value
Length of time until expiration
Volatility of futures price
Interest Rates
Time Value for Mar 08 and Dec 07 Options on Nov 1, 2007 : Time Value for Mar 08 and Dec 07 Options on Nov 1, 2007 Mar 08 Futures = 509.25
Mar 08 510 Call Option
Premium = 8.625
Intrinsic Value = 0
Time Value = 8.625
Mar 08 510 Put Option
Premium = 9.5
Intrinsic Value = 0.75
Time Value = 8.75
Dec 07 Futures = 537
Dec 07 540 Call Option
Premium = 20.5
Intrinsic Value = 0
Time Value = 20.5
Dec 07 540 Put Option
Premium = 23.25
Intrinsic Value = 3
Time Value = 20.25
Average Time Value For Harvest Contract Options : Average Time Value For Harvest Contract Options
Slide16 : In-the-money: An option contract that has positive intrinsic value.
Call option with strike price less than the current futures price.
Put option with strike price greater than the current futures price.
Out-of-the-money: An option contract with zero intrinsic value.
Call option with strike price greater than the current futures price.
Put option with strike price less than the current futures price.
Comparison of Futures & Options : Comparison of Futures & Options Futures
Bullish traders go long futures.
Bearish traders go short futures.
All traders deposit margin funds.
Unlimited profit potential.
Unlimited loss potential. Options
Bullish traders go long call options.
Bearish traders go long put options.
Long option positions pay premium, short option positions require margin.
Option buyer - limited loss, unlimited profit.
Option seller - limited profit, unlimited loss.
Break-Even Price : Break-Even Price Underlying futures price at expiration needed to break-even on an option position.
Position Break-Even Price
Call Option Strike Price + Prem.
Put Option Strike Price - Prem.
Call Option Break-Even Price for Jul 2007 Corn Options : Call Option Break-Even Price for Jul 2007 Corn Options Strike Prem. B.E.
500 27 527
510 21.5 531.5
520 16.75 536.75
530 13 543
540 10.25 550.25
- Note the trade-off between the B.E. price and the premium (the higher the break-even price, the lower the premium).
Put Option Break-Even Price for Jul 2007 Corn Options : Put Option Break-Even Price for Jul 2007 Corn Options Strike Prem. B.E.
500 5.5 494.5
510 9.5 500.5
520 14.5 505.5
530 20.25 509.75
540 27.5 512.5
- Note the trade-off between the B.E. price and the premium (the lower the break-even price, the lower the premium).
Example of a Long Call Option : Example of a Long Call Option Nov 1, 2007 - A trader is bullish Jul wheat at a price of 522 but doesn’t want to risk trading futures. She decides to buy a 530 Jul 2008 Call Option for a premium of 13 cents.
Cost of position = 13 cents x 5,000 bu=$650
Loss potential = $650
Profit potential = unlimited.
Break-even price = 530 + 13 = 543.
Long 530 Call Option at 13 cents : Long 530 Call Option at 13 cents Scenario 1 -- Lower Prices
June 20, 2008
Jul 2000 Futures = 505
Intrinsic Value of Call Option=Premium at Expiration
max(0,F-S)=max(0,505-530)=0
Profit = (0 - 13) = -13 cents.
No matter how low prices go, the maximum loss is 13 cents.
If instead, had gone long futures at 522 then the loss would be 17 cents.
Long 530 Call Option at 13 cents : Long 530 Call Option at 13 cents Scenario 2 -- Higher Prices
June 20, 2008
Jul 2008 Futures = 555
Intrinsic Value of Call Option=Premium at Expiration
max(0,F-S)=max(0,555-530)=25
Profit = (25 - 13) = +12 cents.
Each 1-cent move higher above the strike price leads to a 1-cent gain.
If instead, had gone long futures at 522 then the gain would be +33 cents.
Example of a Long Put Option : Example of a Long Put Option Nov 1, 2007 - A trader is bearish Jul wheat at a price of 522 but doesn’t want to risk trading futures. He decides to buy a 530 Jul 2008 Put Option for a premium of 20 cents.
Cost of position = 20 cents x 5,000 bu=$1,000.
Loss potential = $1,000
Profit potential = unlimited.
Break-even price = 530 - 20 = 510.
Long 530 Put Option at 20 cents : Long 530 Put Option at 20 cents Scenario 1 -- Lower Prices
June 20, 2008
Jul 2008 Futures = 205
Intrinsic Value of Put Option=Premium at Expiration
max(0,S-F)=max(0,530-505)=25
Profit = (25 - 20) = +5 cents.
Each 1-cent move below the strike price yields a 1-cent gain to the put option buyer.
If instead, had gone short futures at 522 then the profit would be 17 cents.
Long 530 Put Option at 20 cents : Long 530 Put Option at 20 cents Scenario 2 -- Higher Prices
June 20, 2008
Jul 2008 Futures = 555
Intrinsic Value of Put Option=Premium at Expiration
max(0,S-F)=max(0,530-555)=0
Profit = (0 - 20) = -20 cents.
No matter how high prices go, the maximum loss is 20 cents (the premium).
If instead, had gone short futures at 522 then the loss would be 33 cents.
Example of a Short Call Option : Example of a Short Call Option Nov 1, 2007 - A trader is bearish Jul corn at a price of 522. He decides to sell a 540 Jul 2008 Call Option for a premium of 10 cents.
Premium received = 10 cents x 5,000 bu=$500.
Loss potential = unlimited.
Profit potential = $500.
Break-even price = 540 + 10 = 550.
Short 540 Call Option at 10 cents : Short 540 Call Option at 10 cents Scenario 1 -- Lower Prices
June 20, 2008
Jul 2008 Futures = 505
Intrinsic Value of Call Option=Premium at Expiration
max(0,F-S)=max(0,505-540)=0
Profit = (10 - 0) = +10 cents.
If the futures price ends up below the call option strike price, the call seller will keep all of the premium.
Short 540 Call Option at 10 cents : Short 540 Call Option at 10 cents Scenario 2 -- Higher Prices
June 20, 2008
Jul 2008 Futures = 555
Intrinsic Value of Call Option=Premium at Expiration
max(0,F-S)=max(0,555-540)=15
Profit = (10 - 15) = -5 cents.
Each 1-cent move above the strike price of a call leads to a 1-cent loss for the call option seller.
Example of a Short Put Option : Example of a Short Put Option Nov 1, 2007 - A trader is bullish Jul corn at a price of 522. He decides to sell a 520 Jul ‘06 Put Option for a premium of 14 cents.
Premium received = 14 cents x 5,000 bu=$700.
Loss potential = unlimited.
Profit potential = $700.
Break-even price = 520 - 14 = 506.
Short 520 Put Option at 14 cents : Short 520 Put Option at 14 cents Scenario 1 -- Lower Prices
June 20, 2008
Jul 2008 Futures = 505
Intrinsic Value of Put Option=Premium at Expiration
max(0,S-F)=max(0,520-505)=15
Profit = (14 - 15) = -1 cents.
Each 1-cent move below the strike price leads to a 1-cent loss for the put option seller.
Short 520 Put Option at 14 cents : Short 520 Put Option at 14 cents Scenario 2 -- Higher Prices
June 20, 2008
Jul 2008 Futures = 555
Intrinsic Value of Put Option=Premium at Expiration
max(0,S-F)=max(0,520-555)=0
Profit = (14 - 0) = +14 cents.
If futures is above the put option strike, put seller will keep all of the premium.