How Options "Work"
Let’s get away from the fundamentals of the markets and talk the nuts and bolts of options. No ... don’t run screaming and turn the page! This is painless and it might even help seasoned marketers understand more about options. Let’s start with a basic description of call and put options.
A call option is the right, but not the obligation, to establish a long futures position at a specific price.
The definition is much more complicated than reality. If you buy a $3.50 December corn call, it means you have the right to establish a long position in December futures at $3.50. Of course, you pay for that right (the premium). If December futures rally to $3.80, it makes sense to establish the long position in futures at $3.50, so the call premium increases. If you paid 10¢ for the right to do so, your net entry is $3.60—the strike price plus the premium paid for the call. If you don’t want to be long futures, you can take profits and liquidate the position. In this example, the profit would be about 20¢.
The premium of the call option includes three variables: intrinsic value, time value and volatility. Intrinsic value is determined by how close the strike price is to the actual futures price. A $3.50 December call with December futures at $3.60 means the intrinsic value is a dime. The same call option with December futures at $3.40 has no intrinsic value—that’s why it’s referred to as “out-of-the-money.”
Buying a December call option now means you are buying the right to establish a long position for a long period of time; you pay for that time. Buying a March call option now buys a much shorter period of time, lowering the premium.
Volatility is a measure of how much futures prices are moving. Lackluster trade over a period of time sucks volatility out of option premium. Wild price action increases the volatility value.
The call option premium relationship to the futures price is like the wings on a bird. When futures rise, so does the premium on a call option. When futures fall, so does the premium on a call option
A put option is the right, but not the obligation, to establish a short futures position at a specific price.
If you buy a $3.50 December corn put, it means you have the right to establish a short position in December futures at $3.50. If December futures fall to $3.20, it makes sense to establish the short position in futures at $3.50, so the put premium increases. If you paid 10¢ for that right, your net entry is $3.40—the strike price minus the premium paid for the put. But because you don’t have the obligation to establish a short position, you can liquidate the position and take the profit. In this example, the profit would be about 20¢.
The same three factors that determine the value of a call option also set the premium on a put option. If you own a $3.50 December put option with December futures at $3.40, your put is in-the-money by a dime (the intrinsic value). With December futures at $3.60, your put is out-of-the money (the intrinsic value is zero)—time and volatility make up the bulk of the premium of this put option.
The put option premium relationship to the futures price is a see-saw with futures on one side and the put premium on the other. As the futures price rises, the put premium falls. When futures fall, the put premium rises. That’s why a put option is often called a “price floor.”
Example: You own the cash grain with a long put option to cover downside price risk. If futures fall, the value of the put option increases. The increased value of the put option partially offsets the price decline. Ahead of expiration, you will decide between two choices: “Exercise” the put option to establish a short position in futures at the strike price, or take profits by selling the put back to “the market.”
If you liquidate the position, your downside risk on the cash grain is reopened, and you’ll add the profit on the put option to the cash price when the bushels are sold to determine the net selling price.
If you exercise the put option, your downside risk is now covered by the short futures position (you are hedged). If futures move lower, price risk is 100% covered by the short futures position.
That, however, does not mean this is a risk-free position. Basis is the risk. If basis weakens, lost pennies are deducted from your net selling price. Conversely, basis gains are added to your net selling price.
If futures turn higher and climb above your entry point, you will be exposed to potential margin calls. But—don’t forget you still own the cash grain. Any price movement in futures above your entry on the hedge is offset by gains in the value of your cash grain. That’s why a hedge should only be established when local basis is trading below “normal” levels. The hedge will lock in the price and give basis time to return to normal levels.
When basis does return to normal levels, liquidate the hedge by buying futures to offset the short position (this leaves you with no position in futures), and sell the cash corn at the same time. Your net selling price is the price at which you were hedged plus the basis at the time you make the cash sale.
If you were hedged at $3.50 after exercising your long put option, it doesn’t matter if corn futures are at $2.50 or $4.50, your net selling price is $3.50 plus basis. That’s because one position (futures) offsets the other (cash grain), leaving basis as the only variable in determining the net selling price.