All About Options on Futures Contracts Part 1
This is the first part of the article. Second part is available here: Part 2
All About Options for Farmers
Options are much more complicated than futures. If you do not understand futures, you will be doing yourself a disservice to read this. It will only confuse you.
Options are traded on futures and stocks. This article is about options on futures. Get this solidly in your head:
Call options increase in value if the futures price goes higher and lose value if the futures price goes lower.
Put options increase in value if the futures price goes lower and decreases in value if futures price goes higher.
After you buy an option, one of three things will happen and all three are your choice. You will:
Exercise it (exchange for a futures contract and be subject to margin calls, not always bad!)
Let it expire (because it is worthless on expiration day)
Lesson One Options on Commodity Futures Contracts
I am going to start using an example of real numbers:
March 2019 corn futures settled at $3.80 on Friday, October 5, 2018.
A March $3.80 call settled that same day at 15 cents.
A March $3.80 put also settled at 15 cents.
A call increases in value if the futures market price goes up (call up).
A put increases in value if the futures price goes down (put down).
If you bought a March 2019 $3.80 corn call that day, you bought the right, without the obligation, to buy March 2019 corn futures at $3.80 any business day before the option expired on the third Friday in February or:
You can sell the option at market value any business day before it expires instead of exchanging it for a futures position.
Or you can do nothing, which is what you would do if you still owned it on expiration day and it was worthless.
After you buy the March $3.80 call option, the best that can happen to you is March corn goes to $10 (or more) and you will be paid the difference between $3.80 and $10.00, or $6.20 (or more) per bushel.
If March corn is below $3.80 on the last trading, aka expiration day, the third Friday in February, no one wants to be long March corn futures at $3.80, so the call option is worthless. Thus, you lost the 15 cents plus commission of a cent or so.
If March corn is at $3.81 on expiration day, you could sell the option for one cent a bushel. Why? Because the option can (and will be) be exercised (exchanged for a March futures contract), resulting in a long futures at $3.80 with the futures at $3.81.
If March corn is at $3.94 on expiration day, you could sell the option for 14 cents a bushel because it is 14 cents in-the-money, meaning the resulting futures contract will have a profit of 14 cents. Your net on the option transaction would be a one cent loss because you paid 15 cents for the call option.
If March corn is at $4.80 on expiration day, you will receive $1 a bushel for the option if you sold it because March corn is $1 above $3.80 or it is $1 in-the-money. Your net profit would be 85 cents because you paid 15 cents for it.
In this example, the underlying futures contract is March 2019 corn.
The strike price is $3.80.
The premium was 15 cents when you bought it, but the value of the premium changes as the futures price changes. If the corn futures price goes higher, the premium goes higher and vice versa.
In this example, the day you bought the option, the premium was 15 cents, yet the option had no intrinsic value. This is the amount of profit one would have in the futures market if the option was exercised (option exchanged for a futures contract) at that moment.
If a $3.80 call is exercised, the futures position is established at the strike price, in this example, $3.80. If March corn futures happened to be exactly at $3.80 at that moment, the resulting futures position (if the option was exercised that moment) would have no profit. Thus, the call option would have no intrinsic value, because it was not in-the-money.
Yet, the premium is still 15 cents. Why? That 15 cent premium is the value the market has placed on the probability of March corn being above $3.80 when the call option expires the third Friday in February. That 15 cent premium has a time value of 15 cents and the premium of 15 cents is 100% time value, because there is no intrinsic value (no in-the-money value).
On October 5, 2018, 15 cents premium was the value the market had placed on the probability of March 2019 corn going up, and it was exactly the same value as the probability of March corn going down. That makes sense because the futures price of $3.80 was exactly the same as the strike price of both (call and put) options.
With rare exception, all in-the-money options have intrinsic value and time value. All out-of-the-money options have nointrinsic value, only time value.
On October 5, 2018, a March 2019 $3.70 corn call option had a premium of 21 cents. Since March corn futures contract was at $3.80, a $3.70 call had 10 cents of intrinsic value and 11 cents of time value (10+11 = 21 cents premium).
The longer the life of the option, the greater the time value will be. Each day that passes, the time value is diminished until the last few minutes of expiration day, at which moment the time value will go to zero. Why? There is no more time for that option to increase in value.
Another factor which impacts time value is the volatility of the underlying futures price. If corn prices are moving 10 to 15 cents up and down most days, that extreme volatility increases the probability that the option will have profit when it expires. Therefore, the premium increases. You need to know and understand that an option will have a larger time value in a volatile futures market than it will have with a quiet futures market.
The delta is the ratio of the change in the price of an option to the corresponding change in the price of the futures. For example, if a corn option has a delta of 0.60, if corn futures price changes 10 cents, the option value will change 6 cents.
Lesson Two Which strike price to buy?
There are two schools of thought on that, and they are opposite conclusions based upon the same set of facts.
For call options, the more confident you are that the futures will go higher, the lower the strike price you should buy, which will be more expensive. If you are very confident futures will go higher, investing more money in the premium for a lower strike price call will make much more money than buying a cheap, out-of-the-money call option because the delta is a much higher ratio on the lower strike price, in-the-money call option.
Generally speaking, the less confident you are the price will go higher, the higher the strike price call you should buy because you are risking less money.
But there is another consideration. If you are thinking, but not very confident, corn futures will increase, but only 20 to 30 cents in the coming two months, you will most likely be wasting your money to buy a call option out-of-the-money.
For put options, the more confident you are that the futures will go down, the higher the strike price you should buy, which will be more expensive. If you are very confident futures will go down, investing more money in the premium for a higher strike price put will make much more money than buying a cheap, out-of-the-money put option because the delta is a much higher ratio on the higher strike price, in-the-money put option.
Generally speaking, the less confident you are the futures price will go your way, the less money you should risk, so you buy an option out-of-the-money, perhaps way out-of-the-money.
Before you select a call option to buy, you must decide how high the futures price will likely go and when that high will be made. If you think $4.20 will be the top, there is not much reason to buy a $4.40 call. If you think the high will be made in June, there is not much point to buy a March or May option because they will expire before the June high.
Futures prices trade in increments (ticks) of a quarter cent. Option premiums trade in one-eighth of a cent ticks.
On Oct 5, 2018, March 2019 corn futures settled at $3.80, the following prices for March 2019 corn calls and puts were:
In the above situation:
All call options with a strike price below $3.80 are in-the-money, because if those options were exercised, the resulting futures position would have a profit.
All call options with a strike price above $3.80 are out-of-the-money, because if those options were exercised, the resulting futures position would have a loss.
All put options with a strike price below $3.80 are out-of-the-money, because if those options were exercised, the resulting futures positions would be losing money.
All put options with a strike price above $3.80 are in-the-money, because if those options were exercised, the resulting futures positions would be making money. Read the flowing sentences carefully, and think about each one until all four make sense to you.
In each case, answer the question, “If exercised, would this option create a futures position making money or losing money?”
Call options with strike prices above $3.80 are out-of-the money because futures price is $3.80.
Call options with strike prices below $3.80 are in-the money because the futures price is $3.80.
Put options with strike prices below $3.80 are out-of-the-money because the futures price is $3.80.
Put options with strike prices above $3.80 are in-the-money because the futures price is $3.80.
On January 16, 2019, March 2019 corn futures settled at $3.74.
The March $3.80 corn call settled at an even 5 cents.
The March $3.80 corn put settled at 10¾.
Only one of those options was in-the-money. Which one?
All CBOT options trade the same way.
Lesson Three Who Gets the Premium From the Option Buyer?
All we have discussed is only the purchase of options. Where does the premium go when you purchase an option? The premium goes to the trader who either sold an option he had previously purchased or the trader who wrote the option you purchased. Say what?
To you, as a buyer, it makes no difference if your premium went to a seller or a writer, but it makes a huge difference to the person receiving your premium.
An option seller is selling an option he had previously purchased. Thus, when he sold his option, he is out of the market.
An option writer is selling an option he has not previously purchased. Thus, he is getting in the market, and he is short the option. Being short, he wants the option value (premium) to go down so he can buy the same option at a lower price to offset his short position. Better yet, he wants the option to expire worthless, in which case, he keeps 100% of the option premium and the buyer of the option loses 100% of his premium investment.
The writer of an option is subject to margin calls because he is short the option and he is in-the-market. The seller of an option is not subject to margin calls because he is out-of-the-market.
If you do not understand why the following three statements are true, you need to go back to the beginning and read again. If you understand the difference between a buyer, seller, and writer of an option, then the following makes sense to you:
The buyer of an option has unlimited profit potential and limited loss potential.
The seller of an option is out of the market and has no market risk nor gain potential.
The writer of an option has unlimited loss potential and limited income potential.
Just to be clear:
Long: owner of this position makes money if the value increases
Short: owner of this position makes money if the value decreases
There are four possible option transactions:
Buy an option, an opening transaction (to establish a long option position), can be a call or put.
Write an option, an opening transaction (to establish a short option position), can be a call or put.
Buy an option, a closing transaction (of a previously written call or put option) to get out of the market.
Sell an option, a closing transaction (of a previously purchased call or put option) to get out of the market.
The buyer of a call is long the futures and long a call.
A call increases in value if futures go up.
The buyer of a put is short the futures and long a put.
A put increases in value if the futures go down.
The writer of a call is short the futures and short the call.
A call decreases in value if futures go down.
The writer of a put is long the futures and short the put.
A put decreases in value if futures go up.
The seller of a call is out of the market.
One is selling a call he previously bought.
The seller of a put is out of the market.
One is selling a put he previously bought.
Ways to be long the futures with options:
Buy a call or write a put
Ways to be short the futures with options:
Buy a put or write a call