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Option Terms |
Why Use Options |
Option Valuation |
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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.
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.
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OPTIONS TERMINOLOGY
Option Terms |
Why Use Options |
Option Valuation |
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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
Option Terms |
Why Use Options |
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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 Short T-bond/note
futures position futures position
Seller assumes Short T-bond/note Long T-bond/note
futures position futures position
OPTION PREMIUM VALUATION
Option Terms |
Why Use Options |
Option Valuation |
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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.
Option Terms |
Why Use Options |
Option Valuation |
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