## What Are Futures and Options?

Futures contracts are standardized, legally binding agreements to buy or sell a specific product or financial instrument in the future. The buyer and seller of a futures contract agree on a price today for a product to be delivered or settled in cash at a future date. Each contract specifies the quantity, quality and the time and location of delivery and payment.

The value of a futures contract is derived from an underlying financial measure or market, such as commodity prices, equity index levels, foreign exchange rates or interest rates – hence the term derivatives. As the value of the underlying measure or market changes, the value of the futures contract based on that measure or market also changes. Institutions and individuals that face financial risk based on the movement of the underlying measure or market can buy or sell futures that will change in value to offset that financial risk. Such transactions are known as hedging. Institutions and individuals also buy and sell futures hoping to profit from price changes. These transactions are considered speculation.

Options on futures can be thought of as insurance policies. An option is a contract between a buyer and a seller that gives the buyer of the option the right, but not the obligation, to buy or to sell a futures contract on or before the option’s expiration time, at an agreed price, the strike price. The option buyer pays a price for the right – but not the obligation – to buy or sell a futures contract within a stated period of time at the strike price. The combination of options and futures – both risk-management tools – can give market participants the leverage of futures and the more limited risk of options. The high degree of leverage that is often attainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Options provide the opportunity to limit those losses while maintaining the possibility of unlimited profits from favorable changes in the futures price. Please be advised that trading futures and options involves substantial risk of loss and is not suitable for all investors.

**Option Types**

A put is an option contract giving the owner the right, but not the obligation, to sell a futures contract at a specified price within a specified time. The buyer of a put estimates that the value of the underlying futures contract will drop below the exercise price before the expiration date. A call is an option contract giving the owner the right, but not the obligation, to buy a futures contract at a specified price within a specified time. A call becomes more valuable as the price of the underlying futures contract appreciates.

**Option Premium**

Option premium is determined by basic supply and demand fundamentals. In an open-auction market, buyers want to pay the lowest possible price for an option and sellers want to earn the highest possible premium. There are some basic variables that ultimately affect the price of an option as they relate to supply and demand.

It can be said that option premiums consist of two components:

- Intrinsic value
- Time value

## 1. Intrinsic Value

An option’s premium at any given time is the total of its intrinsic value and its time value. The total premium is the only number you will see or hear quoted. However, it is important to understand the factors that affect time value and intrinsic value, as well as their relative impact on the total premium.

Intrinsic value + Time value = Premium

Intrinsic Value—This is the amount of money that could be currently realized by exercising an option with a given strike price. An option’s intrinsic value is determined by the relationship of the option strike price to the underlying futures price. An option has intrinsic value if it is currently profitable to exercise the option.

A call option has intrinsic value if its strike price is below the futures price. For example, if a soybean call option has a strike price of $6.00 and the underlying futures price is $6.50, the call option will have an intrinsic value of 50 cents.

A put option has intrinsic value if its strike price is above the futures price. For example, if a corn put option has a strike price of $2.60 and the underlying futures price is $2.30, the put option will have an intrinsic value of 30 cents.

Determining Intrinsic Value

Calls: Strike price < Underlying futures price

Puts: Strike price > Underlying futures price

Option Classification

At any point in the life of an option, puts and calls are classified based on their intrinsic value. The same option can be classified differently throughout the life of the option.

In-the-Money—In trading jargon, an option, whether a call or a put, that has intrinsic value (i.e., currently worthwhile to exercise) is said to be in-the-money by the amount of its intrinsic value. At expiration, the value of a given option will be whatever amount, if any, that the option is in-the money. A call option is in-the-money when the strike price is below the underlying futures price. A put option is in-the-money when the strike price is greater than the underlying futures price.

Out-of-the-Money—A call option is said to be out-of-the-money if the option strike price is currently above the underlying futures price. A put option is out-of-the-money if the strike price is below the underlying futures price. Out-of-the money options do not have any intrinsic value.

At-the-Money—If a call or put option strike price and the underlying futures price are the same, or approximately the same, the option is at-the-money. At-the-money options do not have any intrinsic value. To repeat, an option’s value at expiration will be equal to its intrinsic value—the amount by which it is in-the-money. This is true for both puts and calls.

Determining Option Classifications

In-the-money

Call option: Futures price > Strike price

Put option: Futures price < Strike price

Out-of-the-money

Call option: Futures price < Strike price

Put option: Futures price > Strike price

At-the-money

Call option: Futures price = Strike price

Put option: Futures price = Strike price

Calculating an Option’s Intrinsic Value

Mathematically speaking, it is relatively easy to calculate an option’s intrinsic value at any point in the life of an option. The math function is basic subtraction. The two factors involved in the calculation are the option’s strike price and the current underlying futures price.

For call options, intrinsic value is calculated by subtracting the call strike price from the underlying futures price.

- If the difference is a negative number (i.e., call strike price is greater than the underlying futures price), then the call option currently doesn’t have any intrinsic value.

- Example: 22 December soybean oil call when December soybean oil futures is trading at 20 cents. (20 cents – 22 cent strike price = 0 intrinsic value)

- Note. Intrinsic value can only be a positive number (i.e., an option can’t have negative intrinsic value). Therefore, you can say the call option in this example is out-of-the-money by 2 cents but you shouldn’t say that it has a negative 2 cents intrinsic value.

- For put options, intrinsic value is calculated by subtracting the underlying futures price from the put strike price.
- If the difference is a positive number (i.e., the put strike price is greater than the underlying futures price), there is intrinsic value.
- Example: $3.50 March wheat put when March wheat futures is trading at $3.20. ($3.50 strike price – $3.20) = 30 cents of intrinsic value)

- If the difference is 0 (i.e., put strike price is equal to the underlying futures price), then that put option doesn’t have any intrinsic value.
- Example: $3.50 March wheat put when March wheat futures is trading at $3.50. ($3.50 strike price – $3.50 = 0 intrinsic value)

- If the difference is a negative number (i.e., put strike price is less than the underlying futures price), then the put option currently doesn’t have any intrinsic value.
- Example: $3.50 March wheat put when March wheat futures is trading at $3.75. ($3.50 strike price – $3.75 = 0 intrinsic value)

- If the difference is a positive number (i.e., the put strike price is greater than the underlying futures price), there is intrinsic value.

Note. Intrinsic value can only be a positive number (i.e., an option can’t have negative intrinsic value). Therefore, you can say the put option in this example is out-of-the-money by 25, but you shouldn’t say that it has a negative 25 cents intrinsic value.

At the expiration of a call or put option, the option’s premium consists entirely of intrinsic value—the amount that it is in-the-money.

## 2. Time Value

If an option doesn’t have intrinsic value (either it’s at-the-money or out-of-the-money), that option’s premium would be all time value. Time value is the difference between the total premium and the intrinsic value.Total premium – Intrinsic Value = Time value

Time value (sometimes called extrinsic value) reflects the amount of money buyers are willing to pay in expectation that an option will be worth exercising at or before expiration.One of the components of time value reflects the amount of time remaining until the option expires. For example, let’s say that on a particular day in mid-May the November soybean futures price is quoted at $6.30. Calls with a strike price of $6.50 on November soybean futures are trading at a price of 12 cents per bushel. The option is out of the money and therefore, has no intrinsic value. Even so, the call option has a time value of 12 cents (i.e., the option’s premium––its extrinsic value) and a buyer may be willing to pay 12 cents for the option.

Why? Because the option still has five months to go before it expires in October, and, during that time, you hope that the underlying futures price will rise above the $6.50 strike price. If it were to climb above $6.62 (strike price of $6.50 + $.12 premium), the holder of the option would realize a profit.

Length of Time Remaining Until Expiration

Volatility of the Underlying Futures Price

All else remaining the same, option premiums are generally higher during periods when the underlying futures prices are volatile. There is more price risk involved with market volatility and therefore a greater need for price protection. The cost of the price insurance associated with options is greater, and thus the premiums will be higher. Given that an option may increase in value when futures prices are more volatile, buyers will be willing to pay more for the option. And, because an option is more likely to become worthwhile to exercise when prices are volatile, sellers require higher premiums.

Thus, an option with 90 days to expiration might command a higher premium in a volatile market than an option with 120 days to expiration in a stable market.

Other Factors Affecting Time Value

Option premiums also are influenced by the relationship between the underlying futures price and the option strike price. All else being equal (such as volatility and length of time to expiration), an at-the-money option will have more time value than an out-of-the-money option. For example, assume the soybean oil futures price is 24 cents per pound. A call with a 24-cent strike price (an at-the-money call) will command a higher premium than an otherwise identical call with a 26-cent strike price. Buyers, for instance, might be willing to pay 2 cents for the at-the-money call, but only 1.5 cents for the out-of-the-money call. The reason is that the at-the-money call stands a much better chance of eventually moving in the money.

An at-the-money option is also likely to have more time value than an option that is substantially in the money (referred to as a deep in-the-money option). One of the attractions of trading options is “leverage”—the ability to control relatively large resources with a relatively small investment. An option will not trade for less than its intrinsic value, so when an option is in-the-money, buyers generally will have to pay over and above its intrinsic value for the option rights. A deep in-the-money option requires a greater investment and compromises the leverage associated with the option. Therefore, the time value of the option erodes.

Generally, for a given time to expiration, the greater an option’s intrinsic value, the less time value it is likely to have. At some point, a deep in-the-money option may have no time value— even though there is still time remaining until expiration.

Please be advised that trading futures and options involves substantial risk of loss and is not suitable for all investors.

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