Futures Basics - Option

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There are two basic types of options: call option & put option.

A Call Option gives the buyer the right, but not the obligation, to purchase a particular futures contract at a specific price anytime during the life of the option.

A Put Option gives the buyer the right, but not the obligation, to sell a particular futures contract at a specific price anytime during the life of the option.

The price at which the buyer of a call option has the right to purchase the futures contract or the buyer of put option has the right to sell the futures contract is known as the strike price (or exercise price).

The amount of time the purchaser of the option has the right to purchase (call options) or sell (put options) the underlying futures contract is known as the expiration month.

Just as futures contracts are standardized, so are options contracts on futures. Each option has predetermined strike prices and expiration dates. Each options contract can only be offset before expiration by either selling a like option (same commodity, month, and strike price call or put) or by exercising the option at the strike price. The only variable in the equation is the price paid for this right, known as premium.

The biggest factor in determining the price of an option is where the underlying futures contract is in relation to the strike price. A call option with a strike price below the current price of the underlying futures contract has intrinsic value. Intrinsic value is the difference, if any, between the market price of the underlying commodity and the strike price of the option. A call option has intrinsic value if its strike price is below the price of the underlying futures price. A put option has intrinsic value if the strike price is above the current underlying futures price. Any option that has intrinsic value is said to be in the money. As a general rule, the larger the amount of intrinsic value of an option, the higher the premium paid for that option will be.

Time Value

The second major component of an option price - or premium - is time value. Time value is the amount of money that option buyers are willing to pay for an option in the anticipation that over time the price of the underlying futures will change in value, causing the option to increase in value. Time value also reflects the amount of money that a seller of an option requires to relinquish the right to the purchaser. Generally speaking, the longer the amount of time until an option’s expiration, the greater the time value of the option will be.

Volatility

Another component of extrinsic value - or time value - is the volatility of the underlying futures contract. Volatility is the amount of movement in the underlying market over a period of time. Obviously, if prices are jumping up and down and changing by large amounts, obviously the risk and potential reward associated with this market is greater, and hence the price of the option will be greater.