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Understanding Options

Table of Contents
  1. Introduction
  2. Option Terms
  3. Why Use Options
  4. Option Valuation
  5. Motives for Buying and Selling Options
  6. Futures Positions after Option Exercise
  7. Option Premium Valuation

INTRODUCTION

Options on futures contracts have added a new dimension to futures trading. The principal attraction of buying options is that they make it possible to speculate on increasing or decreasing futures prices with a known and limited risk. The most that the buyer of an option can lose is the cost of purchasing the option (known as the option "premium") plus transaction costs. Like futures, they provide price protection against adverse price moves.

Who sells the options that option buyers purchase? The answer is that options are sold by other market participants known as option writers, or grantors. Their sole reason for writing options is to earn the premium paid by the option buyer. If the option expires without being exercised (which is what the option writer hopes will happen), the writer retains the full amount of the premium. If the option buyer exercises the option, however, the writer must pay the difference between the market value and the exercise price. It should be emphasized and clearly recognized that unlike an option buyer who has a limited risk (the loss of the option premium), the writer of an option has unlimited risk. This is because any gain realized by the option buyer if and when he exercises the option will become a loss for the option writer.

Present-day options trading on the floor of an exchange began in April 1973 when the Chicago Board of Trade created the Chicago Board Options Exchange (CBOE) for the sole purpose of trading options on a limited number of New York Stock Exchange-listed equities. Options on futures contracts were introduced at the CBOT in October 1982 when the exchange began trading Options on U.S. Treasury Bond futures.



OPTIONS TERMINOLOGY

There are several important terms the would-be user of options on futures should understand. They include:

call option:
Gives the buyer the right, but not the obligation, to buy a specific futures contract at a predetermined price within a limited period of time.
put option:
Gives the buyer the right, but not the obligation, to sell a specific futures contract at a predetermined price within a limited period of time.
holder:
The buyer of the option.
premium:
The dollar amount paid by the buyer of the option to the seller.
writer:
The option seller.
strike price:
The predetermined price at which a given futures contract can be bought or sold. Also called the exercise price, these levels are set at regular intervals. For example, if Treasury bond futures were at 79-00, T-bond option strike prices would be at 74, 76, 78, 80, 82, and 84.
at-the-money:
An option is at-the-money when the underlying futures price equals, or nearly equals, the strike price. For example, a T-bond put or call option is at-the-money if the option strike price is 78 and the price of the Treasury bond futures contract is at, or near, 78-00.
in-the-money:
A call option is in-the-money when the underlying futures price is greater than the strike price. For example, if Treasury bond futures are at 80-00 and the T-bond call option strike price is 78, the call is in-the-money. The put option is in-the-money when the strike price of the option is greater then the price of the underlying futures contract. For example, if the strike price of the put option is 80 and T-bond futures are trading at 77-00, the put option is in-the-money.
out-of-the-money:
A call option is out-of-the-money if the strike price is greater than the underlying futures price. For example, if T-bond futures are at 80-00 and the T-bond call option has an 82 strike price, the option is out-of-the-money. The put option is out-of-the-money if the underlying futures price is greater then the strike price. For example, if T-bond futures are at 77-00, and the T-bond put option strike price is 76, the put option is out-of-the-money.
  Call option Put option
In-the-money Futures > Strike Futures < Strike
At-the money Futures = Strike Futures = Strike
Out-of-the-money Futures < Strike Futures > Strike

Options are considered "wasting assets." In other words, they have a limited life because each expires on a certain day, although it may be weeks, months, or years away. The expiration date is the last day the option can be exercised, otherwise it expires worthless.

For every option buyer there is an option seller. In other words, for every call buyer there is a call seller; for every put buyer, a put seller. The buyer of the option, unlike the buyer of a futures contract, need not worry about margin calls. However, the seller of the option is generally required to post margin.

If an option position is covered, the seller holds an offsetting position in the underlying commodity itself or a futures contract. For example, the seller of a Treasury bond call option would be covered if he actually owned cash market U.S. Treasury bonds or was long the Treasury bond futures contract.

If the writer did not hold either, he would have an uncovered or "naked" position. In such instances, margin would be required because the seller would be obligated to fulfill terms of the option contract in the event the contract is exercised by the buyer. It is imperative, therefore, that the seller demonstrate the ability to meet any potential contractual obligations beforehand. In addition, the seller of uncovered options on interest rate futures assumes the potential for significant losses.



MOTIVES FOR BUYING AND SELLING OPTIONS

One may be a buyer or seller of call or put options for a variety of reasons.

  • Buying Calls

The buyer of a call option acquires the right but not the obligation to purchase (go long) a particular futures contract at a specified price at any time during the life of the option. Each option specifies the futures contract which may be purchased (known as the "underlying" futures contract) and the price at which it can be purchased (known as the "exercise" or "strike" price). A March Treasury bond 84 call option would convey the right to buy one March U.S. Treasury bond futures contract at a price of $84,000 at any time during the life of the option.

A call option buyer is bullish. That is, he or she believes the price of the underlying futures contract will rise. A call option buyer will realize a net profit if, upon exercise, the underlying futures price is above the option exercise price by more than the premium paid for the option. Or a profit can be realized it, prior to expiration, the option rights can be sold for more than they cost.

To summarize, there are three courses of action available.

  1. to exercise the option and acquire the underlying futures contract at the strike price.
  2. The second is to offset the long call position with a sale and realize a profit.
  3. The third, and least acceptable, is to let the option expire worthless and forfeit the unrealized profit.

Example: You expect lower interest rates to result in higher bond prices (interest rates and bond prices move inversely). To profit if you are right, you buy a June T-bond 82 call. Assume the premium you pay is $2,000. If, at the expiration of the option (in May) the June T-bond futures price is 88, you can realize a gain of 6 (that's $6,000) by exercising or selling the option that was purchased at 82. Since you paid $2,000 for the option, your net profit is $4,000 less transaction costs. As mentioned, the most that an option buyer can lose is the option premium plus transaction costs. Thus, in the preceding example, the most you could have lost--no matter how wrong you might have been about the direction and timing of interest rates and bond prices--would have been the $2,000 premium you paid for the option plus transaction costs.

In contrast if you had an outright long position in the underlying futures contract, your potential loss would be unlimited. It should be pointed out, however, that while an option buyer has a limited risk (the loss of the option premium), his profit potential is reduced by the amount of the premium. In the example, the option buyer realized a net profit of $4,000. For someone with an outright long position in the June T-bond futures contract, an increase in the futures price from 82 to 88 would have yielded a net profit of $6,000 less transaction costs. Although an option buyer cannot lose more than the premium paid for the option, he can lose the entire amount of the premium. This will be the case if an option held until expiration is not worthwhile to exercise.

  • Selling Calls

The seller of the call option expects futures prices to remain relatively stable or to decline modestly. If prices remain stable, the receipt of the option premium enhances the rate of return on a covered position. If prices decline, selling the call against a long futures position enables the writer to use the premium as a cushion to provide downside protection to the extent of the premium received. For instance, if T-bond futures were purchased at 80-00 and a call option with an 80 strike price was sold for 2-00, T-bond futures could decline to the 78-00 level before there would be a net loss in the position (excluding, of course, margin and commission requirements).

However, should T-bond futures rise to 82-00, the call option seller forfeits the opportunity for profit because the buyer would likely exercise the call against him and acquire a futures position at 80-00 (the strike price).

  • Buying Puts

The perspectives of the put buyer and put seller are completely different. The buyer of the put option believes prices for the underlying futures contract will decline. As in the case of call options, the most that a put option buyer can lose, if he is wrong about the direction or timing of the price change, is the option premium plus transaction costs. For example, if a T-bond put option with a strike price of 82 is purchased for 2-00, while T-bond futures also are at 82-00, the put option will be profitable for the purchaser to exercise if T-bond futures decline below 80-00.

In many instances, puts will be purchased in conjunction with a long cash or long T-bond futures position for "insurance" purposes. For instance, if an institution is long T-bond futures at 82-00 and a T-bond put option with an 82 strike is purchased for 2-00, the futures contract could, theoretically, fall to zero and the put option holder could exercise the option for the 82 strike price, assuming the option had not yet expired.

Another Example: Expecting a decline in the price of gold, you pay a premium of $1,000 to purchase an October 320 gold put option. The option gives you the right to sell a 100 ounce gold futures contract for $320 an ounce. Assume that, at expiration, the October futures price has--as you expected-declined to $290 an ounce. The option giving you the right to sell at $320 can thus be sold or exercised at a gain of $30 an ounce. On 100 ounces, that's $3,000. After subtracting $1,000 paid for the option, your net profit comes to $2,000. Had you been wrong about the direction or timing of a change in the gold futures price, the most you could have lost would have been the $1,000 premium paid for the option plus transaction costs. However, you could have lost the entire premium.

  • Selling Puts

The seller of put options on fixed-income securities believes interest rates will stay at present levels or decline. In selling the put option, the writer, of course, receives income. However, if interest rates rise, the buyer of the put option can require the writer to take delivery of the underlying instrument at a price greater than that in the new market environment.

Since an option is a wasting asset, an open position must be closed or exercised, otherwise the option expires worthless. The chart below illustrates what happens to the buyer and the seller after an option is exercised.

FUTURES POSITIONS AFTER OPTION EXERCISE

Call option Put option
Buyer assumes Long T-bond/note
futures position
Short T-bond/note
futures position
Seller assumes Short T-bond/note
futures position
Long T-bond/note
futures position


OPTION PREMIUM VALUATION

Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers. Major variables influence the premium for a given option.

  • Price Value

    The price (value) of an option premium is determined competitively by open outcry auction on the trading floor of the CBOT. The premium is affected by the influx of buy and sell orders reaching the exchange floor. An option buyer pays the premium in cash to the option seller. This cash payment is credited to the seller's account.

    The relationship between the exercise price and the current price of the underlying futures contract. All else being equal, an option that is already worthwhile to exercise (known as an "in-the-money" option) commands a higher premium than an option that is not yet worthwhile to exercise (an "out-of-the-money" option). For example, if a gold contract is currently selling at $295 an ounce, a put option conveying the right to sell gold at $320 an ounce is more valuable than a put option that conveys the right to sell gold at only $300 an ounce.

    Prices for T-bond and T-note futures contracts are quoted differently from the options premiums on these futures. Options on these contracts are quoted in 64th of a point. Therefore, a quote of -01 in options means 1/64, in futures, 1/32.

    The option premium has two components: "intrinsic value" and "time value." The intrinsic value is the gross profit that would be realized upon immediate exercise of the option. In other words, intrinsic value is the amount by which the portion is in-the-money. (An option that is out-of-the- money or at-the-money has no intrinsic value.)

    For example, in December, a June Treasury bond futures contract is priced at 82-00, while the June 80 call is priced at 3 10/64. The intrinsic value of the option is 2-00:

    Bond futures 82-00
    Option strike price 80-00
    Intrinsic value 2-00
    • Time Value

    Time value reflects the probability the option will gain in intrinsic value or become profitable to exercise before it expires. In other words, all else being equal, an option with a long period of time remaining until expiration commands a higher premium than an option with a short period of time remaining until expiration because it has more time in which to become profitable. An option is an eroding asset. Its time value declines as it approaches expiration

    Time value is determined by subtracting intrinsic value from the option premium:

    Time value = Option premium - Intrinsic value
    = 3 10/64 - 2-00
    = 1 10/64
    • Volatility

    The volatility of the underlying futures contract. All else being equal, the greater the volatility the higher the option premium. In a volatile market, the option stands a greater chance of becoming profitable to exercise. Volatile prices of the underlying commodity can stimulate option demand, enhancing the premium; thus, buyers pay more while writers demand higher premiums.

    Some parallels can be drawn between the time value component of an option premium and the premium charged for an automobile insurance policy. The longer the term of the policy, the greater the probability a claim will be made by the policyholder. This, of course, presents a greater risk to the insurance company. To compensate for this increased risk, the insurer charges a greater premium. For example, the total dollar cost of a one-year policy to insure the vehicle will be greater than a six-month policy since the vehicle is being insured for twice as long. The same is true with options on interest rate futures-the longer the term until expiration, and the more volatile the underlying market, the greater the option premium.



     

    Disclaimer and Important Risk Warning:

    You should understand that trading in the futures and or options markets is not for everyone. There is substantial risk of loss when trading futures and or options. Carefully evaluate whether trading in the futures and or options markets is appropriate, as such trading is speculative in nature. When trading futures, you may sustain losses which exceed your margin deposits. Purchasing options may result in the entire loss of premiums paid for such options. Options sellers should understand that they may be at risk of assuming a long futures position in the case of selling a put or a short futures position in the case of selling a call from the respective strike prices of such options. Past results are not necessarily indicative of future results.
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