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Options on Futures Basics
There are
two basic types of options:
A
Call Option gives the buyer the right,
but not the obligation, to purchase a
particular futures contract at a
specific price anytime during the life
of the option.
A
Put Option gives the buyer the right,
but not the obligation, to sell a
particular futures contract at a
specific price anytime during the life
of the option.
The price
at which the buyer of a call option has the
right to purchase the futures contract or
the buyer of put option has the right to
sell the futures contract is known as the
strike price (or exercise price).
The amount
of time the purchaser of the option has the
right to purchase (call options) or sell
(put options) the underlying futures
contract is known as the expiration month.
Just as
futures contracts are standardized, so are
options contracts on futures. Each option
has predetermined strike prices and
expiration dates. Each options contract can
only be offset before expiration by either
selling a like option (same commodity,
month, and strike price call or put) or by
exercising the option at the strike price.
The only variable in the equation is the
price paid for this right, known as premium.
The price
of an option is a function of where the
underlying futures market is in relation
to:
-
The
strike price
-
Time to Expiration
-
Volatility
Option
prices are based on these factors, and are
determined in trading pits in a fashion very
similar to futures.
Strike
Price
The biggest
factor in determining the price of an option
is where the underlying futures contract is
in relation to the strike price. A call
option with a strike price below the current
price of the underlying futures contract has
intrinsic value. Intrinsic value is the
difference, if any, between the market price
of the underlying commodity and the strike
price of the option. A call option has
intrinsic value if its strike price is below
the price of the underlying futures price. A
put option has intrinsic value if the strike
price is above the current underlying
futures price. Any option that has intrinsic
value is said to be in the money. As a
general rule, the larger the amount of
intrinsic value of an option, the higher the
premium paid for that option will be.
If an
option has no intrinsic value, it is said to
be either at-the-money or out-of-the-money.
An at-the-money option is one where the
underlying futures price is equal to the
strike price of the option. If a call
option has a strike price higher than the
current underlying futures price, the option
is said to be out-of-the-money. If a put
option has a strike price below the current
underlying futures price, the put option is
said to be out-of-the-money. At-the-money
and out-of-the-money options have what is
known as extrinsic value or time value.
Options
and the Money
| |
Call |
Put |
|
In-The-Money |
Futures>Strike |
Futures<Strike |
|
At-The-Money |
Futures=Strike |
Futures=Strike |
|
Out-Of-The-Money |
Futures<Strike |
Futures>Strike |
Time Value
The second
major component of an option price - or
premium - is time value. Time value is the
amount of money that option buyers are
willing to pay for an option in the
anticipation that over time the price of the
underlying futures will change in value,
causing the option to increase in value.
Time value also reflects the amount of money
that a seller of an option requires to
relinquish the right to the purchaser.
Generally
speaking, the longer the amount of time
until an option’s expiration, the greater
the time value of the option will be. This
is because the right to buy or sell
something is more valuable to a market
participant if he/she has several months to
decide what to do, than if he/she only has
several days. Conversely, the option seller
has more risk over time that the option will
go in-the-money (or stay in-the-money) and
thus demands more premium in exchange for
selling the right to buy or sell over a
longer period of time.
Because
options have extrinsic value, or time value,
they are decaying assets. As time passes,
the amount of time value decreases. The rate
of decay of time value increases as you get
closer to expiration, speeding way up close
to six weeks until expiration. Hence, for
the option purchaser, time is the enemy,
slowly eroding the value of an option
Volatility
Another
component of extrinsic value - or time value
- is the volatility of the underlying
futures contract. Volatility is the amount
of movement in the underlying market over a
period of time. Obviously, if prices are
jumping up and down and changing by large
amounts, obviously the risk and potential
reward associated with this market is
greater, and hence the price of the option
will be greater.
Guidelines
Generally,
when one is looking at buying options, they
should look to buy at-the-money options with
at least 3 or more months left on them.
If one is
looking at selling options, they should look
to sell out-of-the-money options with less
than 3 months until expiration.
For more information on options, please
refer to the
either
The Chicago Mercantile Exchange’s FREE guide to
Options on Futures
or
The National Futures Association FREE guide to
Buying Options on
Futures Contracts: A Guide to Uses and Risks
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