Option Fundamentals

Source: Orion Futures Group, Inc.

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, If 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.