Options on Futures

What is a Futures Option?

• Gives the buyer, the right, but not the obligation to take on a

futures market position.

• Pay a price for this right, but once paid there is no other cost

unless you choose to exercise the option.

• Two types of options:

A call option gives its owner the right to buy something.

A put option gives its owner the right to sell something.

Every option contract has both a buyer and a seller Puts and

Calls are separate option contracts; they are not the opposite

side of the same transaction.

• Options Analogy

• Options can be written for almost anything of value

• They can be a written agreement.

• Example Buying a house or any valuable asset

or

• Exchange traded options

• Grains

• Metals

• Livestock

• Stocks

• Bonds

• ETF’s

Underlying Asset

• Options are available on a wide variety of

investments including stocks, bonds, currencies and

commodities.

• For the purpose of this lesson we will use “Grain

Futures” options traded on the CBOE (Chicago

Board Options Exchange)

Types of Options

• A call option gives its buyer the option to purchase

an agreed quantity of a commodity or financial

instrument (asset), from the seller of the option by a

certain date, for a certain price

• A put option gives its buyer the right to sell the

underlying asset at an agreed-upon price before the

expiry date.

Buyers and Sellers

• Every Option requires that there be a buyer and a

seller

• All options are traded through a clearing house

• Buyers and sellers are anonymous

• Exchange traders will take the opposite side of a

trade where there is no bid or ask.

• Key point …..

oFor every buyer there is a seller

oFor every seller there is a buyer

CALL Option (Buyer)

• Long the call (bullish)

• Also called the holder

• Acquires the right to buy

• Pays premium

• Specific price & time

• Has right to exercise

• No obligation

• Limited loss position

• Unlimited gain position

PUT Option (Buyer)

• Owns (long) the put

• Also called the put holder

• Acquires the right to sell

• Pays premium

• Specific price & time

• Has right to exercise

• No obligation

• Limited loss position

• *Unlimited gain position

Questions

Call Options give their holder

A The obligation to Buy the underlying futures contract at a

fixed price?

B The right to Sell the underlying futures contract at a fixed

price?

C The right but not the obligation to Buy the underlying

futures contract at a fixed price?

D The right but not the obligation to Sell the underlying

futures contract at a fixed price?

Questions

Put Options give their holders the right to:

A. Sell the underlying derivative

B. Sell a call

C. Buy the underlying derivative

D. Buy a call

The process by which a futures contract is terminated

by a transaction that is equal and opposite from the

one that initiated the position is called?

A. Open Interest

B. Offset

C. Delivery

Questions

Options Characteristics

• Have an expiration date

• Can be used as a hedging instrument

• Can be used to amplify profits

• Cost a fraction of the underlying product

• Strike Price/ Exercise Price Intervals

• Part of the premium is time value

• The more time left, the more expensive the option

• Options lose value with time

• Holders and Writers

Strike Price (Exercise Price)

• The price at which the buyer or holder of a “Call”

has the right to purchase a futures contract

or

• The price at which the buyer of a “Put” has the right

to sell a futures contract when the option is

exercised.

Strike price = Exercise price

Strike Price

• The closer to the Strike price the more costly the

option

• The more time value in the option the more costly

the option

• Many levels are assigned

• Many months are assigned

• Near the money are high volume

Premium

• The “Cost” component paid or received for the

option.

• Represents the maximum the option buyer can lose.

• Premium can include both “Time” and “Intrinsic”

value.

• The premium is the only term of the option that is

negotiated.

Corn Option Math

• Corn Contract = 5,000 bushels

• Options are priced in cents per bushel

• 1 cent move in price = 1¢ x 5,000 bu or $50.00

• Minimum move is 1/8 of a cent or $50 / 8 = $6.25

• Therefore an option priced at 5’1 = 5 1/8 cents or $256.25

• An option priced at 5’ 7 = 5 7/8 or $293.75

• In the Money Option

• A Call option is in-the-money when the futures price exceeds the

strike price.

• A Put option is in-the-money when the futures price is below the strike

price.

• At the Money Option

• The option strike price and the underlying futures price are roughly

the same.

• Out of the Money Option

Call option: The underlying futures price is below the option

strike price.

Put option: The underlying futures price is above the option

strike price.

• At expiration, the option will have no value, and the holder will

allow it to expire worthless.

Exercise

• The action taken by the buyer of an option to

acquire or sell the underlying futures position

Expiration Date

• The last date upon which an option can be

exercised.

• If it is not exercised or sold before close of business

it becomes worthless.

• Options that are “in the money” or have intrinsic

value will need to be offset or they will be

automatically exercised.

• It is important to understand the clearing rules

regarding the options you are trading.

How Premium is Derived

Intrinsic Value (Net Worth)

+

Extrinsic Value (Time Value + Volatility)

=

Premium of Option

Intrinsic Value

March Corn $3.50 per bushel

• March $3.40 Call 22 cents or $1,100

• Intrinsic Value 10 cents or $ 500

• March $3.50 Call 16 cents or $800.

• Intrinsic Value 0 cents or $000.

Extrinsic Value

March Corn $3.50 per bushel

• March $3.40 Call 22 cents or $1,100

• Intrinsic Value 10 cents or $ 500

• Extrinsic/Time Value 12 cents or $ 600.

• March $3.50 Call 16 cents or $800.

• Intrinsic Value 0 cents or $000.

• Extrinsic/Time Value 16 cents or $800.

Time Value

Which of the following options will yield a profit to the

purchaser?

A. An expired option that is "at the money."

B. A call option when the price of the underlying commodity

increases above the option's strike price by an amount

greater than the premium paid for the option.

C. A put option when the price of the underlying increases

above the option's strike price by an amount greater than the

premium paid for the option.

Question 1

Question 2

November Soybean contract is $8.50 per bushel

Strike price for a CALL option on a Nov. Soybean is

$8.80 per bushel

Is the option in-the-money, at-the-money, or out-of

the-money?

Question 3

March Soybean contract is $8.50 per bushel

The strike price for a PUT option on a March futures

contract is $8.80 per bushel

Is the option in-the-money, at-the-money, or out-

of-the-money?

Option Holder (buyer)

• Holder (long)

• Pays option premium

• Maximum loss is premium

• Maximum profit is unlimited to zero

• Owns option and all of the rights till expiry

• Your decision whether or not to exercise

• Limited exposure

OPTION PRICING

MARCH WHEAT 410.

CALLS PUTS

Time Intrinsic Change LastStrike

PriceLast Change Time Intrinsic

1 40 6 41.0 370.00 3.1 1.2 3.1 0

4.5 30 4.5 34.5 380.00 4 2.2 4 0

7 20 3.6 27 390.00 7 3 7 0

12 10 3.5 22 400.00 11.1 3.5 11.1 00

17 0 3.1 17 410.00 16.5 4.1 16.5 00

13 0 2.6 13 420.00 22 4.5 12 10

10.4 0 2.2 10.4 430.00 29 5.2 9 20

7.4 0 1.2 7.4 440.00 35 6.1 5 30

5.4 0 1.1 5.4 450.00 43 6.4 3 40

4.1 0 1 4.1 460.00 51.3 6.6 2.3 50

3.1 0 0.6 3.1 470.00 61.5 7.2 1.5 60

2. The buyer (holder) of an option can:

a) Exercise the option

b) Sell the option

c) Allow the option to expire

d) Do any of the above

Questions

Basic Option Strategies

• Buying Puts The right to sell a futures contract at a

given price

• Buying Calls The right to buy a futures contract at a

given price

• Covered Call

• Bull Spreads

Why Buy Puts

• To protect or hedge producer from falling prices

• To speculate on prices going lower

Why Buy Calls

Farmer:

• To maintain a position in the market after you have contracted

your grain.

Speculator:

• To profit from an anticipated rise in the price of grains

Strategy 1

Farmer feels Corn prices are adequate for profit

• His choices include

• Sell his corn on forward contract

Pros

• Profit locked in

Cons

• farmer cannot share in gains if the market moves higher

Strategy 2

Farmer buys a Put option for price protection

Pros

• Farmer is protected from the strike price down on a price

deterioration

• If prices continue to rise, farmer still own his crop and the

maximum loss is the premium paid for the option

Cons

• Farmer pays premium for the option

• Basis is not protected unless he hedges CAD $

Brokerage Account

Canadian firms CIPF protection

Type of Account Spec or hedge

Hedge account Preferred commissions

Proper paperwork for taxes

Services

• Online discount Experienced traders. Less expensive

• Broker assisted Answer basic questions

• Full Service Most expensive, trading advice

Brokerage Services

Full Service Brokers Most expensive

Broker assisted.. Less expensive and will assist with trading

Discount (online) Brokers