Options Fundamentals

The Fundamentals of Commodity Futures Options
Options on futures have the same fundamental characteristics as stock options except that the underlying asset is a futures contract involving a commodity or financial instrument, rather than shares of stock. An option on a futures contract gives the buyer or owner (also called the “holder”) the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) the underlying futures contract, at an agreed upon price (known as the “strike price”), on or before the option expiration date. Options on futures are traded at the same exchanges that trade the underlying futures contracts and are standardized with respect to the quantity of the underlying futures contracts, expiration date, and strike price (the price at which the underlying futures contract maybe bought or sold). An option has a limited life and is considered to be a “wasting” asset – its value declines as time passes. It may even expire worthless, or the holder may have to exercise it in order to recover some value before expiration. Of course, the holder may also choose to sell the option in the marketplace prior to expiration.

An option owner (or “holder”) who invokes the right to buy or sell the underlying futures contract is said to “exercise” the option. Call option holders exercise in order to go long the underlying futures contract, whereas put holders exercise to go short. The option holder may exercise the option at any time after purchasing it, right up to the last trading day, but he or she does not have to wait until expiration date before exercising. Whenever an option holder exercises an option, somewhere an option seller (or “writer”) is “assigned” the obligation to fulfill the terms of the option contract. Thus, if a call holder exercises the right to go long the underlying futures contract at the strike price, a call writer is assigned the obligation to sell at this price. Conversely, if a put holder exercises his or her right to assume a short position in the underlying futures at the strike price, the put writer is obligated to assume a long position at that price.

Out of the Money, In-the-money, Intrinsic Value and Premium
A Call option is said to be “out-of-the-money” if the underlying futures contract is trading below the strike price of an option. (For example, Corn Futures are trading at $9 a bushel and you buy a $9.50 call) A call option is “in-the-money” if the underlying futures is trading above the call option’s strike price. (For example, you buy a $9.00 corn call and the underlying futures is trading at $9.30/bushel) Put options work in the exact opposite fashion: A put is out-of-the-money if the underlying futures is trading above the option’s strike price. (For example, Corn Futures is trading at $9.30/bushel and you buy a $9.00 put). An in-the-money put is one whose strike price is greater than the price at which the underlying futures is currently trading. (For example, you buy a $9.00 put and the futures is trading at $8.90/bushel.
The “intrinsic value” of an in-the-money call option is the amount by which the underlying futures exceeds the strike price. If the call is out-of-the-money, its intrinsic value is zero. Puts work in the opposite fashion. The intrinsic value of an in-the-money put is the amount by which the option’s strike price exceeds the current price of the underlying futures. If a put’s strike price is lower than the current futures price, the put is out-of-the-money, and its intrinsic value is zero.

The “premium” is the price at which an option is trading in the marketplace. The premium is comprised of time value + intrinsic value. If an option is out-of-the-money, then it has no intrinsic value, and the entire premium will consist of time value. (For example, of Corn futures are trading at $9.00 and you buy a $9.50 call option). An option normally has the greatest amount of time value when the underlying futures is trading at or very near to the strike price. As an option becomes deeply in-the-money or out-of-the-money, time value shrinks considerably. An option is said to be trading at “parity” with the underlying futures contract if it is trading for its intrinsic value, with no time value.

Four Factors That Determine Options Prices
An Option’s price is the result of properties of both the underlying futures and the terms of the option. The 4 major factors that determine an options price are as follows:
1: Strike price of the option
2: Time remaining till expiration of the option
3: Price of the underlying futures contract
4: Volatility of the underlying futures contract

These factors are the major determinants of an options price, but the relationship between the futures price and the options strike price is critical—if the futures price is either far above or far below the option’s strike price, the other factors have little influence. Its dominance is obvious on the day the option expires—on that day, only the relationship between the futures price and option strike price determine the option’s value—the other factors have not bearing at all. At this time, the option is worth only its intrinsic value.

Why Trade Options?
Now that you have a better idea of what commodity options are and how they work, let’s briefly outline some of the important advantages of commodity options trading. For additional information, we suggest you visit our Options 101 page. There are three general reasons for commodity options trading:

1. Speculate on the Direction of Market Prices
For those with a high level of risk tolerance, commodity options trading provides an opportunity to use relatively moderate sums of money to leverage sizable positions. For a fraction of what it would cost to buy large quantities of an actual commodity—like Silver, Australian Dollar, or Crude Oil, for instance—investors can buy calls giving them the right, but not the obligation, to buy futures contracts at a specific price (strike).

For a real world example, please consider the following example: Suppose an investor is bullish on the outlook of Soybean prices and wishes to participate by purchasing 10,000 bushels. At the current price of Soybeans of $6.23 per bushel, the investor could expect to pay $62,300, plus storage fees. Using options, the same investor might buy 5 November Soybean $6.40 calls for $.30 per bushel. Now, for just $7,500 (5 options x $.30 x 5,000 bushels per contract), the investor owns the rights to buy 25,000 bushels of Soybeans at $6.40, any time before the call options expire. Let’s say the price of soybeans is $8.00 per bushel at expiration, in which case the options will be worth $1.60 each ($8.00 - $6.40) or $40,000 (5 contracts x $1.60 x 5,000 bushels each). The investor will have a profit of $32,500 on a $7,500 investment, a return of more than 400%.

In contrast, the investor who actually spent the $62,300 to purchase 10,000 bushels of Soybeans at a price of $6.23 per bushel will earn a profit of $17,700 ($8.00 - $6.23 x 10,000 bushels). This amounts to a return-on-investment of just 28%, and it illustrates the power of leverage. It’s this kind of leverage—the ability to control large quantities of a commodity asset with a relatively modest investment—that attracts many speculators to futures and options. However, be forewarned that leverage is a double-edged sword, and the risks are equally high. In our example, the trader’s November soybean 640 calls will be worthless—and he’ll lose his entire $7,500 investment—if prices are below $6.40 at expiration. In this case, the investor who bought cash soybeans will have lost nothing, because he still owns the physical asset.


2. Hedge Against Adverse Commodity and Financial Price Moves

One of the most conservative commodity options trading strategies is to help protect assets against adverse price fluctuations. Again, let’s consider an example to help illustrate this point. Suppose you’re concerned about a potential decline in stock markets prices. To protect the value of your portfolio, you should consider buying a put option as a hedge. If stock prices decline, your put option will gain in value, offsetting some or all of your stock losses. The risk is simply that stock prices rise instead of fall, the option will likely expire worthless, and your stock profits will be reduced by the amount you paid for the put. But think of this as an insurance policy—the put will help protect your portfolio against a sell-off, and if prices rise, well, you’ll simply write-off the cost of the put. The way this works is fairly straightforward. First, you will need to decide which put options to purchase, and that depends on the makeup of your stock portfolio. Does your portfolio contents most resemble the Dow Jones? The S&P 500? The Russell 2000?

The Nasdaq Composite?
Let’s imagine you own a pretty diversified portfolio of large-cap, blue chip stocks, worth about $250,000. To protect your investment, you might consider buying a put option. With September S&P 500 futures trading at 1180.00, you decide to purchase a put option with a strike price of 1170 and an expiration date several months away. If the stock market declines in the coming weeks, the put will gain in value, thereby hedging your stock portfolio—gains on the put option help offset some or all of your stock losses. Of course, the best scenario would be for the stock market to rally, in which case your put would expire worthless. Either way, knowing that you have protection to the downside might just help you breathe easier.

3. Generate Additional Income on Your Futures Position
Another common, relatively conservative commodity options strategy is “covered call writing.”  Many traders use this strategy to generate additional trading profits. This strategy entails establishing a long futures position in a market you believe will rally, and then selling an out-
of-the-money call option. The options on more volatile commodities tend to be more expensive, so they generate more income when you sell the covered calls. If you would rather be more conservative, choose a less volatile commodity, because it is less likely you will be forced to sell it. The trade-off is that you won’t earn as much income because the options on less volatile commodities are less expensive. In either case, here’s how the strategy works:

Imagine you expect the Coffee market to rally. The price for December Coffee is around 125.00, and your upside objective is 150.00. Accordingly, you buy 5 futures contracts and wait for the price to begin climbing. If you now were to sell 5 calls with a strike price of 150 against the long futures contracts in your account, they would be considered “covered.” Even if the market rallies higher than 150.00, your long futures position will more than offset the option losses. For this reason, the position is far less risky than uncovered (naked) calls that, by definition, are written without a long futures position. If the December 150.00 calls are trading at 4.40, you could sell 5 contracts, generating $8,250 in proceeds ($3.75 x 4.40 x 5 contracts). Now, all you have to do is hope the December futures contract remain at or below 150.00. If it does, you keep the $8,250. If the futures rally to 160.00, you have two choices. First, you could buy the calls back. Or, you could wait for the assignment, and you would be short 5 December futures contracts at 150.00. In this case, you still keep the $8,250 premium you collected from selling the calls. In addition, you capture the profit associated with the futures move from 125.00 to 150.00.