Introduction
Options on futures contracts have added a new dimension
to futures trading. Like futures, options provide price protection
against adverse price moves. 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.
Table of Contents:
Reasons for using Options
Options differ considerably from futures. When used
prudently, options can be of immense importance, especially in
attempting to preserve the value of an existing fixed-income portfolio.
To many in the financial markets, options are considered
"insurance" against adverse price movements while offering the
flexibility to benefit from possible favorable price movement.
The reasons for using options on futures are reflected
in the structure of an option contract.
First, an option, when purchased, gives the buyer
the right, but not the obligation, to buy or sell a specific amount
of a specific commodity at a specific price within a specific
period of time. By comparison, a futures contract requires a buyer
or seller to perform under the terms of the contract if an open
position is not offset before expiration.
Second, the decision to exercise the option is entirely
that of the buyer.
Third, the purchaser of the option can lose no more
than the initial amount of money invested (premium). That is not
the case, however, for the buyer of a futures contract.
Finally, an option buyer is never subject to margin
calls. This enables the purchaser to maintain a market position,
despite any adverse moves without putting up additional funds.
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.
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Motives for Buying
and Selling Options
One may be a buyer or seller of call or put options
for a variety of reasons.
A call option buyer, for example, is bullish. That
is, he or she believes the price of the underlying futures contract
will rise. If prices do rise, the call option buyer has three
courses of action available.
The first is to exercise the option and acquire the
underlying futures contract at the strike price. The second is
to offset the long call position with a sale and realize a profit.
The third, and least acceptable, is to let the option expire worthless
and forfeit the unrealized profit.
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).
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. 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.
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 |
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Option Premium
Valuation
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.
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 reflects the probability the option
will gain in intrinsic value or become profitable to exercise
before it expires.
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
Several other factors also have an impact on the premium.
One is the relationship between the underlying futures price and
strike price. The more an option is in-the-money, the more it
is worth. A second factor is volatility. Volatile prices of the
underlying commodity can stimulate option demand, enhancing the
premium. The greater the volatility, the greater the chance the
option premium will increase in value and the option will be exercised;
thus, buyers pay more while writers demand higher premiums.
A third factor affecting the premium is time until
expiration. Since the underlying value of the futures contract
changes more within a longer time period, option premiums are
subject to greater fluctuation.
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.
Source: National Futures Association; published here
with permission.
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