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Option
Terms | Why
Use Options | Option
Valuation | Return
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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
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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
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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 | Return
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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.
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