Options Education
Options Overview
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 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 (premiums plus commissions and fees). 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.
The price (value) of an option premium is determined
competitively by open outcry auction on the trading floor of the Exchange.
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.
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.)
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. 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.
Motives for Buying/Selling Options
One may be a buyer or seller of call or put options
for a variety of reasons.
A call options 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.
If it doesn't the investor may lose his initial premium plus commissions
and fees. 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.
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.
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.
More On Options
Options might be considered as wasting assets. In other words,
they have a limited life because each expires on a certain day, although
it may be days or months 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.