Call and Put Options

Before we can progress, we need to understand options terminology. 

⇒ Calls And Puts  

Options come in two varieties: call and put options.


Call Option Definition

A call option buyer acquires the right (but not the obligation) to buy a particular futures contract at a specified price at any time during the life of the option (usually a few months.) A buyer of a call option hopes to profit from an increase in the futures price of the underlying commodity (also called ‘underlying instrument’, ‘underlying contract’ or ‘underlying asset’)

For example, you believe the price of gold is going up. So you buy a March 500 gold call option, paying a premium of $1,100. This option gives you the right to buy a 100 ounce gold futures contract (the underlying commodity) for $500 an ounce. Suppose that sometime before the expiration of the option the price of gold goes up just as you had anticipated. So gold is now selling for $540 an ounce. As the owner of the call option you can either exercise the option, meaning that you can buy the underlying commodity (the 100 ounce gold contract) at the stipulated price of $500 an ounce, and then sell back the futures gold contract in the open market for its current market price of $540 an ounce. Or, you can avoid all that trouble, and simply sell back the option at the current price of $540 an ounce, representing a gain of $40 an ounce. On 100 ounces your total gain is $40 x 100 = $4,000. Minus the $1,100 premium, your net profit is $2,900 (Broker's commission not factored in).

The person who sells the option receives in return the nonrefundable payment known as the premium (The seller of an option is said to be in a short position. The buyer of an option is said to assume a long position) 


Put Option Definition

A put option buyer acquires the right (but not the obligation) to sell a particular futures contract at a specified price at any time during the life of the option (usually a few months.) A buyer of a put option hopes to profit from a decrease in the futures price of the underlying commodity. Exactly the opposite of what you want to happen when you buy a call.

For example, you think the price of gold is going down. So you buy a March 500 gold put option, paying a premium of $1,100. The option gives you the right to sell a 100 ounce gold futures contract (the underlying commodity) for $500 an ounce. As you expected, the price of gold dropped to $440 an ounce. Being the owner of the put option, you can either exercise the option, meaning that you can sell the underlying commodity (the 100 ounce gold contract) at the stipulated price of $500 an ounce,4 and then buy back the gold contract in the open market for $440 an ounce, pocketing the $60 an ounce difference. Or you can simply sell back the option at the stipulated price of $500 an ounce and realize a gain of $60 an ounce. On 100 ounces your total gain is $60 x 100 = $6,000. Minus the $1,100 premium, your net profit is $4,900.

A point to clarify is that you  can sell a commodity even if you don’t own it. This is explained later in ‘Offsetting Transactions’.
 

 ⇒ Strike Price

This is the exercise price. In other words, it’s the specified price in which the buyer of the option has the right to purchase a specific futures contract, or at which the buyer of a put has the right to sell a specific futures contract. In our gold futures contract example, the striking price was $500 an ounce in both cases. Expressed simply as 500.


⇒ Premium

This is the money that an option buyer is requested to pay, or that an option seller demands to receive at the time of the transaction. In other words, it’s the price of the option. In our gold example, it was $1,100. You’ll normally find this amount expressed without dollar signs. So when you’re quoted an option at 5, it means the premium is $500. In our gold example, a broker would have stated that the “option was at 11”.

Essentially, premiums are arrived at through open competition between buyers and sellers on the trading floor of the exchanges, in the same way that prices of commodities are arrived at. This means that the whole process of establishing a premium on an option is strictly a function of supply and demand. When the price of a commodity is rising, the demand for call options rises accordingly, and the premiums set for that particular futures contract will be higher. In contrast, when the price of a commodity is falling, the demand for put options rises accordingly, and the premiums set for that particular futures contract will be higher.

So you can see why the premium price can vary month to month. While an option might be worth a premium of $1,100 one month, it could drop to $200 or $300 the next month. Or it could jump to $2,000 or $3,000. The two components that contribute directly in the value of a premium are: time value and intrinsic value.

In short:    PRICE OF AN OPTION = PREMIUM   AND   PREMIUM = INTRINSIC VALUE + TIME VALUE    
 
      

⇒ Intrinsic Value and Time Value

An option’s premium is made up of two parts.

Its intrinsic value is the part of the premium that is in the money. Its time value is any difference after that. In other words, time value is the amount by which the option’s premium is above the option’s intrinsic value.

Time value reflects any extra amount that a buyer is willing to pay for the option, (or the seller is willing to accept) hoping that any changes in the underlying contract’s price during the life of the option will increase its intrinsic value. Therefore, the premium of an option that’s at the money or out of the money, is entirely a reflection of its time value.

Time value declines over the life of the option. So the time value of an option is worth less and less as the expiration date approaches, because there’s less time remaining for the option to develop intrinsic value. At expiration time, the time value of an option is zero. This is why an option is said to be a wasting asset.

Consequently, the farther away from the expiration date of an option, the higher the time value of the option.

Example:  It’s January and you buy a May 650 soybeans call option (650 is the strike price and it means $6.50 per bushel). The premium for this call option is 10 cents, in other words, $500 (Soybeans trade in contracts of 5,000 bushels. So 10 cents x 5,000 bushels = $500).

At the time you purchased the option, soybeans were trading for $6.50 a bushel. This means you were at the money, so the entire value of the option’s premium represents time value. 

In the money:
when the market value of the underlying asset is higher than the call’s striking price, or lower than the put’s striking price. It means the option is already worthwhile to exercise and commands a higher premium. For example, you buy a gold call option and pay a premium of 3 points ($300). The strike price is 500 at the time when gold is going for $400 an ounce. Or, you buy a gold put option and pay a premium of 3 points ($300). The strike price is 500 at the time when gold is going for $600 an ounce.

At the money:
when the market value of the underlying asset is the same as the striking price of the option. In this case, the option has no intrinsic value. For example, you buy a gold call option and pay a premium of 2 points ($200). The strike price is 500 at the time when gold is going for $500 an ounce.

Out of the money:
when the market value of an underlying asset is lower than the call’s striking price or higher than the put’s striking price (the exact opposite of in the money.) In this case, the option has no intrinsic value. For example, you buy a gold call option and pay a premium of 2 points ($200). The strike price is 500 at the time when gold is going for $400 an ounce. Or, you buy a gold put option and pay a premium of 2 points ($200). The strike price is 500 at the time when gold is going for $600 an ounce.

 

 

 

 

 

 

 

 

This means you’re putting up the $500 premium just because of your perception of the market, and your expectation that the underlying commodity – in this case soybeans – will go up in price. You have no intrinsic value right now:

                     $6.50    market price of soybeans  
                   – $6.50    strike price of option     
                          $0    intrinsic value

Suppose that during the life of the option, the price of soybeans goes up to $7.20 a bushel.
Now you’re in the money, and your option has intrinsic value:                                                                               

                     $7.20    market price of soybeans  
                   – $6.50    strike price of option     
                     $0 .70    intrinsic value    

If you decide to exercise your option right now you’ll make:                                                                                                                                          

                     0.70 x 5,000 bushels = $3,500 less premium 500
                                   = $3,000 profit (minus commissions) 
                                                                                      

What’s more, those who want to get in on this option are going to have to pay a higher premium for it.  


Now let's suppose instead that the price of soybeans dropped to $6.25 a bushel. Your option is now out of the money. Again, you’ve got no intrinsic value at this point.

                      $6.25    market price of soybeans
                    – $6.50    strike price of option
                      ($0.25)   intrinsic value                                                                                   

In essence, when you buy an option and you pay a premium, you can easily recognize how much of that premium is time value and how much of it is intrinsic value. Simply compare the current market value of the underlying commodity with the option’s strike price.


NOTE: An option that is ‘deep’ out of the money (when there’s a more substantial difference between striking price and market price)  will have less time value than an option that is only slightly out-of-the-money. Simply because it would be more difficult for the deep out of the money option to become profitable.

 

⇒ Exercising An Option

To exercise the option means that you elected to take ownership of the underlying asset. In other words, if you exercise a call option you are purchasing the underlying futures contract at the option’s strike price. Thus, you’ve acquired a long position on that futures contract. Likewise, if you exercise a put option you are selling the underlying futures contract at the option’s strike price. You would then be acquiring a short position on the underlying futures contract.

 

⇒ Expiration Date

This is the last date on which the option can be either exercised or offset. One important feature here, is that the expiration of a futures option is one month before the expiration of the futures contract. The month that is stated on the futures option actually corresponds to the futures contract. In other words, using our previous example, we purchased a 650 May soybeans call option. The month of May actually stands for the underlying soybeans futures contract expiration. But the option itself expires in April

It's always a good idea to check the exact expiration date of the option with your broker. And remember, once the option expires you lose your premium.                                                


⇒ Offsetting An Option                                                          

Anytime prior the expiration of the option, you can liquidate the option. In other words, when you sell back an option you had already bought, you’re offsetting the option. This is called an offsetting transaction.   

In the same manner, you can short sell an option. How do you sell something you don’t own? Well, you borrow it first, and then you sell it. Just like when you borrow a book from the public library, you’re expected to bring it back. When you sell an option through the futures exchange, you’ll have a ‘pending offsetting transaction’ waiting. It’ll be satisfied when you buy back the option through an offsetting transaction in that same exchange.

As a practical matter, you, I, and almost everyone else would offset their option. Very few options are ever exercised. Most options are offset. What is bought is usually sold back, and what is sold short is usually repurchased.

What happens if you couldn’t buy or sell back your option? Well, then you would have to exercise the option. However, this is extremely unlikely! One of the most attractive features of the options market is that it is very liquid. Options trade in major exchanges worldwide. Traders are buying and selling all the time.

Being practically assured that you’ll be able to offset an opening transaction via a closing transaction is one of the benefits of trading options.

 

⇒ Commissions                       

Commissions for trading call and put options vary from broker to broker. But unlike commissions on futures contracts, commissions on options usually aren’t round-turn (Round-turn covers both the opening transaction and the closing transaction). You’re charged a commission when you buy an option and when you sell an option. So you need to check with your broker about his commission schedule on options. Also, you’ll be charged the normal fees that you’re charged in a futures contract. That is, NFA and CTFC fees, exchange fees, etc. They’ll vary, but could be in the neighborhood of $50+.

 


In addition to these basic components of an option that we’ve just covered, there are a few other terms you might come across:

⇒ Volatility

This is a measure of the degree or likelihood of price change in a commodity (or stock, or index), during an X amount of time (usually 12 months.) The higher the volatility, the greater the chance of the commodity moving in price (in either direction, since volatility is not direction-biased.) Conversely, the lower the volatility of a commodity (or stock, or index), the less chance of a price move.

So naturally, if you’ve just bought a call or a put option, you’re going to want to see the underlying commodity move. Thus, you’ll want a high volatility option. On the other hand, if you’re selling an option, you’ll want to see the price of the commodity remain fairly stable throughout the life of the option. Of course, you can use this reasoning in reverse. If you think a certain commodity will not be experiencing any considerable volatility in the near future, you might put in place a strategy of selling call or put options.

In contrast, if you do think the commodity will go through substantial volatility, you might consider buying call or put options. Of course, even if you’re right about the volatility, you might not necessarily be right about the direction of the price move. However, as you’ll learn in ahead, there are strategies you can use – such as straddles and spreads – which allow you to profit in both directions!

One simple way to compute volatility, is to subtract the lowest price from the highest price reached during a twelve month period, and then divide the difference by the annual low, and then multiply by 100:

       Highest price in 12 months  - Lowest price in 12 months    x 100
                               Lowest price in 12 months

You may also come across a term called statistical volatility. This simply refers to the level of volatility that this commodity (or stock, or index), has shown in the past. Though statistical volatility is taken into account when pricing an option, what really gives the option more value is the likelihood that the price will have big moves in the future, regardless of what it has done in the past. After all, as we all know, the past is not always a predictor of the future. So as you may imagine, an option that’s considered highly volatile will cost more that one that has low volatility.

This is why you don’t always get the whole story just by looking at the price of the option. For instance, the premium you might have to pay for a particular corn option that’s in the money might appear expensive at first. But if the price of corn is expected to move sharply over the next several weeks, then from a volatility point of view the price of this option is actually very cheap. On the other hand, a cheap corn option might appear very appealing, but if the likelihood of the price of corn moving anytime soon is very low, in other words, if it’s a low volatility option, than it’s not such a great deal as you might have thought.

 

⇒ Delta  

This is the relationship between changes in the option’s premium and changes in the price of the underlying commodity. In other words, it tells you how much your option will make or lose as the price of the underlying commodity goes up or down.

For instance, say the delta for a March 5.50 soybeans call is 35. This would mean, that as the owner of a call option you have the equivalent of 0.35 of a long futures contract. If the price of soybeans goes up 10 ticks, your option will appreciate 3.5 ticks. If the price of soybeans goes down 10 ticks, then your option would lose 3.5 ticks of value.

Likewise, if the delta of a March 3.30 corn put is 25, as the owner of the put option you would have the equivalent of 0.25 of a short futures contract. So, if the price of corn goes up 10 ticks, your option would lose 2.5 ticks of value. In turn, if the price of corn goes down by 10 ticks, then your put option will appreciate 2.5 ticks.

 

Next: Buying a Call Option