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When we talk about securities margin and futures margin, we are talking about two very different things. Understanding the difference is important.

In the securities world, margin is the money you borrow as a partial down payment, up to 50% of the purchase price, to buy and own a stock, bond or ETF. This practice is often referred to as buying on margin.

In futures markets, margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment and you do not own the underlying commodity.

The good news is that futures margin generally represents a smaller percentage of the notional value of the contract, typically 3-12% per futures contract as opposed to up to 50% of the face value of securities purchased on margin.

Margin requirements may fluctuate based on market conditions. When markets are changing rapidly and daily price moves become more volatile clearinghouse margin methodology may result in higher margin requirements to account for increased risk. In contrast, when market conditions and the margin methodology warrant, margin requirements may be reduced.

Types of Margin

There are two main kinds of margin in the futures markets: initial margin and maintenance margin.

Initial margin is the amount required by the exchange to initiate a futures position. While the exchange sets the margin amount, your broker may be required to collect additional funds for deposit.

Maintenance margin is the minimum amount that must be maintained at any given time in your account. If the funds in your account drop below this level, you may receive a margin call requiring you to add funds immediately to bring the account back up to the initial margin level.

If you do not or cannot meet the margin call, you may be able to reduce your position in accordance with the amount of funds remaining in your account, or your position may be liquidated automatically once it drops below the maintenance margin level.

A small change in a futures price can translate into a huge gain or loss, so understanding how futures margin works is essential to maximize the capital efficiencies that futures afford.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Put-Call Parity

Individuals trading options should familiarize themselves with a common options principle, known as put-call parity.

Put-call parity defines the relationship between calls, puts and the underlying futures contract.

This principle requires that the puts and calls are the same strike, same expiration and have the same underlying futures contract.  The put call relationship is highly correlated, so if put call parity is violated, an arbitrage opportunity exists.

The formula for put call parity is c + k = f +p, meaning the call price plus the strike price of both options is equal to the futures price plus the put price.

Using algebraic manipulation, this formula can be rewritten as futures price minus call price plus put price minus strike price is equal to zero f – c + p – k = 0. If this is not the case, an arbitrage opportunity exists.

For example, if the futures price is 100 minus the call price of 5, plus the put price of 10 minus the 105 strike equals zero.

Say the futures increase to 103 and the call goes up to 6. The put price must go down to 8.

Now say the future increases to 105 and the call price increases to 7. The put price must go down to 7.

As we originally said, if futures are at 100, the call price is 5 and the put price is 10. If the futures fall to 97.5, the call price is 3.5, the put price goes to 11.

If a put or call does not adjust in accordance with the other variables in the put-call parity formula, an arbitrage opportunity exists.  Consider a 105 call priced at 2, the underlying future is at 100 so the put price should be 7.

If you could sell the put at 8 and simultaneously buy the call for 2, along with selling the futures contract at 100, you could benefit from the lack of parity between the put, call and future.

Market Outcomes

Look at different market outcomes demonstrating that this position allows individuals to profit by arbitrage regardless of where the underlying market finishes.

The futures price finished below 105 at expiration. Our short 105 put is now in-the-money and will be exercised, which means we are obligated to buy a futures contract at 105 from the put owner.

When this trade was executed, we shorted a futures contract at 100, therefore our futures loss is $5, given the fact that we bought at 105 and sold at 100. This loss is mitigated by the $8 we received upon the sale of the put. The put owner forfeited the $8 when he exercised his option.

Our long 105 call expires worthless,  so we forfeit the $2 call premium. This brings our net profit to $1 with the loss of $5 from the futures and loss of $2 from the call and the gain of $8 from the put.

Another scenario, the futures price finished above 105 at expiration. Our long 105 call is now in-the-money allowing us to exercise the call and buy a futures contract at 105. Because we exercised the option, our $2 premium is forfeited.

When this trade was executed, we shorted a future at 100, therefore our futures loss is $5. The $8 we received from the sale of the put is now profit because it expired worthless.  If you add up the $8 gain from the put, less the $5 loss from the futures and $2 loss from the call you would net a profit of $1.

If the futures end exactly at 105, both options expire worthless. We lose $5 on the futures and make net $6 in options premium, therefore, we net $1.

We stated earlier that put-call parity would require the put to be priced at 7. We have now seen that a put price of 8 created an arbitrage opportunity that generated a profit of $1 regardless of the market outcome.

Put-call parity keeps the prices of calls, puts and futures consistent with one another. Thus, improving market efficiency for trading participants.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Understanding Options Volatility

Volatility is the bounciness of the underlying asset of an option.

There are complicated formulas for measuring realized volatility, there are complicated formulas for forecasting volatility, and there are also complicated formulas for calculating implied volatility.

Temperature Change Example

For example, we will look at temperature changes that may occur in different parts of the world. In Singapore, the temperature swings over the course of a year only vary by 15 degrees from the coldest temperature to the hottest. In Bismarck, North Dakota, those same temperatures swings can be as much as 80 degrees. Thus, the temperature volatility is much greater in Bismarck than in Singapore.

Asset Class Example

You can also compare the bounciness of natural gas prices to corn prices.

If we look at price changes in percentage terms for natural gas versus corn, we see the natural gas price change, whether up or down, is larger than the corn price change. Therefore, natural gas is bouncier than corn.

Volatility as Measure of Bounciness

Volatility as a measure of bounciness, is simply a standard deviation of the underlying asset.

In the options world, volatility is quoted as an annualized number. You can calculate a one year, one standard deviation move,by taking the volatility times the underlying price.

For example, if the underlying price was 100 and volatility was 20%, a one standard deviation move would be 20 points, up or down. This would create an expected price range of 80 to 120.

Time Horizons

If you have a different time horizon, we can calculate that as well by adjusting the volatility by using the square root of time. For a one-month period, the standard deviation would be 20% times the square root of 1/12. The square root of 1/12 is 0.289. Therefore, the range from an initial price of 100 would be 94.2 to 105.8 in one month. For a one-week period, the standard deviation would be 20% times the square root of 1/52. A one standard deviation range for a week, would be 97.2 to 102.8.

Summary

The bounciness of an asset is referred to as volatility, which is the standard deviation. In the options world, that standard deviation is always annualized. The standard deviation can be scaled to different time periods.

We have demonstrated how you could compare the bounciness, or volatility, of different underlying assets by annualizing the standard deviations of those assets.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Introduction to Theoretical Pricing Models

Option pricing is based on the unknown future outcome for the underlying asset.

If we knew where the market would be at expiration, we could perfectly price every option today. No one knows where the price will be, but we can draw some conclusions using pricing models.

When looking at call options, a higher strike will cost less than a lower strike.

If the underlying asset price has risen dramatically and you chose a higher strike price rather than a lower strike, your payoff will be less because you have foregone the first part of the upward price movement.

For Example

To get an idea of how much the premium should be at each strike, we are going to use a simple model.

Assume an asset is priced at $100 and has the characteristic of moving one dollar each month (either up or down). In this model, we will assume the price movement repeats every month over the life of the option and the option expiration will occur in four months.

What is the probability for each of the possible price outcomes after four months? In this model there are 16 possible paths that lead to each of the five price outcomes. The probability of each outcome can be calculated by aggregating the paths for each price.

The probability of reaching any one price point in this model is the number of paths in that price point divided by the total number of paths.

Now that we have the probability for each price point, we can start pricing options with different strike prices. First, you need to know the payoff for each strike price at the defined price level.

For example, the 97 call with an underlying price level of 96, would be an out of the money option. The payoff is zero.

At a price level of 98, the 97 call is now in the money, and the payoff is $1. At 100, the payoff is $3, at 102 the payoff is $5 and at 104 the payoff would be $7.

To find the probability weighted payoff, we multiply the probability for each price point by the payoff amount. The theoretical price for a 97 call would be the sum of the probability weighted payoffs. In this case the sum would be 3.0625.

Continuing the mathematics for each strike price we see the 101 strike has a theoretical price of .4375 and the 103 strike has a theoretical price of.0625.

It should be no surprise the 103 strike has less value than the 101 strike as the probability of it being in the money is much less.

Summary

Traders use proprietary models to determine if the prices in the marketplace are in line with their views. We have shown you a very simple binomial model. Which assumes that the market will move a set amount, either up or down, over each period.

Even the more advanced models still provide only estimates for the option price and are still based on assumptions about the future.

These theoretical pricing models provide options traders the ability to track and measure option prices.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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The profit and loss of an option position at expiration is a function of the original premium and the difference in price between the futures contract and the strike price of the option.

Selling a Call Scenario

Suppose you sell the 105 call for $2 in premium. The maximum profit potential for this trade is $2. Let’s look at a few different possible outcomes for the futures price at expiration.

To understand the profit and loss, we look at the math for each of these potential scenarios. You sold the option and collected $2 in premium. For each scenario the premium column will be $2 and the strike price is $105. This is the price at which you are obligated to sell the futures contract if you are assigned.

Sell Call Scenario One

In scenario one, the futures price at option expiry is $112. This option will be in the money and you would be assigned. You will sell the future for $105 creating an instantaneous $7 loss on the future. You collected $2 in premium and lost $7 on the future, so your net loss will be $5.

Sell Call Scenario Two

For scenario 2 we see the futures price at option expiry is $106. This option is also in the money and again you would be assigned. You will sell the future at the strike price of $105 and have a loss of $1 on the future. Since you collected $2 in premium you will have a net profit of $1.

Sell Call Scenario Three and Four

In scenario 3, the futures price at option expiry is $100. This option is out of the money and will not be exercised. There will be no loss from futures. Therefore, your $2 collected in premium will become your total profit.

Scenario 4 has the futures price at $94. This example is like scenario 3; the option will be out of the money and will not be exercised. Again, your final net position will be a profit of $2.

Buying a Call Scenario

Now let’s look at the same group of scenarios but from the buyer’s perspective.

In this case you buy a call at $105, and pay a $2 premium to the seller. We will look at your profit and loss potential using the same futures prices at option expiration.

Buy Call Scenario One

In scenario one, the futures price at option expiration will be $112. This option is in the money. You exercise the option at $105. With the futures at $112, this will result in a gain of $7. If you subtract the $2 premium paid for the option, your net profit will be $5.

Buy Call Scenario Two

For scenario two, the futures price at option expiration will be $106. Again, this option is still in the money. You exercise this option at $105 and make $1. You paid $2 in premium, so your net will be a loss of $1.

Buy Call Scenario Three and Four

Scenarios three and four are both out of the money options. In both cases you would not exercise the option. Your net loss has been capped at $2 which is the full premium paid for the option.

Summary

These scenarios show you two views of profit and loss from either side of the same transaction. When looking at profit and loss potential of an option position at expiration, you will need to consider the original premium and the difference in price between the futures contract and the strike price of the option.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Value of an Option

When traders talk about the value of an option contract, they tend to use a common set of terms to describe the varying levels of an option contract. The terms they use are time until expiration, time value, intrinsic value, and moneyness.

Moneyness

Moneyness is a term to describe whether a contract is either “in the money”, “out of the money”, or “at the money”.

A call option is said to be “in the money” when the future contract price is above the strike price. A call option is “out of the money” when the future contract price is below the strike price.

DID YOU KNOW? –  Approximately 20% of the total volume at CME Group is Options Volume.   This is impressive given that options have been around only about 35 years while futures have a much longer history—150  years.

For a put option, the contract is said to be “in the money” when the future contract price is below the strike price, and “out of the money” when it is above the strike price. The term “at the money” refers to the strike that is closest to the underlying futures contract. When this happens both the call and the put option will be “at the money” at the same time.

The terms “in the money” and “out of the money” refer to the option contract itself and do not represent the profitability of your trade, nor does it depend on whether you have bought or written the option.

Time Value & Intrinsic Value

When an option is in the money it is said to have intrinsic value, and when the contract is out of the money it has no intrinsic value. When an option expires out of the money, traders will say that contract has “expired worthless”. Intrinsic value is the value of the option if it expired at this moment.

Up to this point we described the value of an option contract at the point of expiration, but what is the value of the contract before expiration?

The value of an option is comprised of two parts, the intrinsic value and the time value. When added together, they give you the “option value”.

Option Value = Intrinsic Value + Time Value

When an option contract expires, the time value would be zero. At this point the option value is equal to the intrinsic value.

Option Value = Intrinsic Value + 0

Let’s look at an example when the option has time value greater than zero. Suppose a call option will expire in one month. Here the option value will be higher than the intrinsic value. Even as the futures contract price moves around, the option value will still be greater than the intrinsic value, and that difference is the time value.

As time moves towards expiration, the time value shrinks or decays. The time value of an option (before its expiration date) will always be greatest when the option is at the money.

You can see the entire option value will always be greater than the intrinsic value until it reaches expiration.

Summary

There you have it, you now know how to use terms like moneyness, time value, and intrinsic value to express the value a put or call option.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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