Put Options Lesson 8: Time Value

What is Time Value of an Option?

This is the eighth essay discussing how to use put options to enhance your grain marketing was written after the close Monday, April 25, 2022.

For the second day in a row, September 2022 CBOT wheat settled 2 cents lower today, at $10.71¼. Also, for the second day in a row, the September $10 and $9 puts lost value. The $10 put lost 5 cents and the $9 put lost 1 3/8 cents.

As you should already know, puts are supposed to increase in value when the futures price goes down. So what is going on?

The puts are losing time value. Every day, options lose one day of life. Therefore, the probability of an option making money also diminishes. When the futures move only 2 cents on a given day, the time value becomes the primary market mover for option premiums (values).

On April 18th, September wheat settled at $11.23¼. The $10 put settled at 50 cents even.

If a person exercised a $10 put (exchanged the option for a futures contract), it would become a short (sold) futures position at $10. With futures at $11.23¼, that short futures positon at $10 would have a loss of $1.23¼.

Why would anyone pay 50 cents for the right to sell September wheat at $10 if September wheat is at $11.23¼?

First of all, they expect September wheat to decline, but the main reason is margin calls!

If a person sells a futures contract and the price goes up, the futures loss must be matched penny for penny every day.

If a person buys a put option and the futures price goes up, no margin calls. It is really that simple. The prospect of margin calls is why most traders are willing to pay so much for options.

With September wheat futures price at $11.23¼ on April 18th, the futures must decline $1.23¼ to be even with the strike price. That $10 put option was $1.23¼ out-of-the-money on the 18th.

With yesterday’s settlement at $10.71¼, the $10 put was 71¼ cents out-of-the-money.

In both situations, the premium value of the option was determined by the market’s assessment of the probability that September wheat will be below $10 on August 26th, 2022, its expiration date.

When an option is out-of-the-money, 100% of the premium is time value.

Think about this: Was the September $11 put out-of-the-money on the close today? September futures settled at $10.71¼. The answer is between your ears.

Who wants to be short (sold) September wheat at $11.00 with the market at $10.71¼?

Or would you rather be short (sold) at $10 with the market $10.73¼?

If you do not immediately know the answer to those two questions, it is because you do not understand how the futures market works. Learn how the futures market works before you try to understand options on futures contracts.

This chart is the closing numbers for September 2022 CBOT wheat puts April 25, 2022: