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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.

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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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American Versus European Style Options

European and American style options are not regional options. They are actually terms used to describe two different types of option exercise.

European Style Options: can be exercised only at expiration.

American Style Options: can be exercised at any time prior to expiration.

The majority of CME Group options on futures are European style and can be exercised only at expiration. The notable exceptions are the quarterly options on the S&P500 futures contracts. These are the only options available for trade with American style expiration.

Even though most CME Group options are European-style and can be exercised only at expiration, it is important for traders to understand style of option they are interested in trading.

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Peter Knight Advisor

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Exercise and Assignment

Options buyers exercise their options.

Options sellers are assigned when an option is exercised.

Exercising your right

A call option is the right to buy the underlying future at the strike price. The process for activating that “right”, is called “exercising the right” or simply to “exercise” the option. For a call option, that activity is also referred to as “calling the underlying” away from the option seller.

Options buyers (either put or call buyers) are the only ones that control whether an option can be exercised.  Option sellers have the obligation if assigned and thus have no control over the exercise procedure.

A put option gives the owner of the option, the right to “put” the underlying future, to the seller of the option. Imagine if a store offers a “30 day no questions asked return policy”, that is like a “put”. You can “put” the item back on the store’s shelf and get a refund. If you return the item to the store, you have “exercised your right” to sell the item back to the store.

Option buyers are the only options traders who can “exercise” the right. Call owners, those who are “long the call”, can exercise their right to buy the underlying at the strike price. And put owners, those who are “long the put”, can exercise their right to sell the underlying at the strike price.

Being assigned

Sellers of call options are obligated to sell you that future, at a specific price. They were paid a premium to take on the risk of having to sell you something at a lower price than the current market.

Similarly, the writers of put options are obligated to buy that future at the specific price, that is higher than the current market price.

When an option owner exercises the right embedded in the contract, someone has to be assigned the duty of fulfilling the obligation, and it may not be the original person who sold the option.

The process of assigning options is performed by the central clearing house. CME Clearing using an algorithm to randomize the assignment to the options sellers.

Summary

Options owners exercise their contracts when markets move in their favor. Sellers of options accept premium and could be assigned when markets benefit the buyers.

Long call option upon exercise results in long futures

Short call option upon assignment results in short futures position (futures called away)

Long put option upon exercise results in short futures position

Short put option upon assignment results in long futures position (long futures put into their account)

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Peter Knight Advisor

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Option Expiration: A.M. or P.M.

Every option contract has a specific expiration date, and time. The time of expiration can be either in the morning (a.m.) or in the afternoon (p.m.).

Options that expire at the close of the market are considered p.m. and options that expire the morning of the last trading day are a.m.

The vast majority of options on futures expire at the close of the market on the last trading day, but there are notable exceptions. Options with a.m. expiration are generally written on a future contract that has the same expiration date and time. Futures that are financially settled, meaning they settle to cash payments rather than physical commodities, are often settled using a.m. expiration.

Exercise Examples

In the case of the S&P500 futures contracts, the final settlement price is determined by the opening prices of all the individual companies that make up the index. This settlement calculation is performed by the index administrator. For the S&P500 indices, the administrator is the Standard and Poor’s Company and they will provide a Special Opening Quote (SOQ), to indicate the final settlement price.

Options on those futures use the SOQ as a fixing price, to determine whether the option will be exercised, by comparing the SOQ to the strike price. For example, if a call option has a strike that is below the SOQ, it will be exercised. By exercising the option, the future will now be purchased at the strike price and on the same day be settled at the more advantageous SOQ price.

Options with a p.m. expiration are calculated using the value of the underlying future at the close of market on the last trading day for the option.

Summary

Although most options expire at the end of a trading day, it is important for traders to understand not only the date, but the specific time when their option may expire.

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

Regards,
Peter Knight Advisor

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Put Options

A put option is the right to sell the underlying futures contract at a certain price.

Buying Puts

When traders sell a futures contract they profit when the market moves lower. A put option has a similar profit potential to a short future. When prices move downward the put owner can exercise the option to sell the futures contract at the original strike price. This is when the put will have the same profit potential as the underlying futures.

However, when prices move up you are not obligated to sell the future at the strike price, which is now lower than the futures price because that would create an immediate loss.

Why would any trader short a future instead of buying a put?

The potential to profit on a put option does not come without a cost. The “seller” or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a put option pays a premium to the seller of a put option.

As a result of the added cost of the premium, the profit potential for a put is less than the profit potential of a futures contract by the amount of premium paid. The price of the futures contract must fall enough to cover the original premium for the trade to be profitable.

The breakeven point for a put is where the profit on the futures contract that you can purchase at the strike price is equal to the premium paid for the call.

Selling Puts

For every long put option buyer, there is a corresponding put option “writer” or seller. If you have written the put option, then you receive the premium in return for the accepting the risk that you may need to buy a futures contract at a higher price than the current market price for that future.

While Put option sellers don’t have unlimited risk, the risk of writing puts can still be very large. The most a put option seller can lose is the full strike price minus the premium received.  If you sell a 100 put option, and the underlying future drops to 20.  You will have an 80pt loss minus the premium you took in which will only offset a small portion of the loss.  In reality, most futures contracts don’t lose 80 percent of their value as in the example above, but losses on ANY short option can be substantial…so do your homework and fully understand the risks.

Put sellers will profit as long as the futures price does not fall beyond the value of the premium received subtracted from the strike price.  For example, if you sell a 100 put strike and receive a premium of 6.00 pts.  You will profit as long as the future is above 94 (strike minus the put premium).

The breakeven point is exactly the same for the put seller as it is for the put buyer.

Summary

Put options are the right to sell the underlying futures contract. Buyers of the put have some protection against adverse price movements in that they have limited risk (only the premium paid is at risk). On the other hand, hedgers can also use puts to protect against a declining price.  Sellers of put options collect premium and accept the risk they may have the underlying “put” into their account resulting in a long futures position, a position that might be at a price much higher than is currently trading in the market.

Using our put selling example, if you sold the 100 put and the price of the underlying declined to 80 at expiration.  If the buyer exercised his option, you would be assigned and have the futures put to you at 100 despite the fact it was trading fully 20 points lower in the market. While buyers have limited risk when buying puts and calls, the seller has substantial and virtually unlimited risk.

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

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Peter Knight Advisor

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Strike Price 

One key characteristic of an option contract is the agreed upon price, known as the strike price or exercise price.

The strike price is the predetermined price at which you buy (in the case of a call) or you sell (in the case of a put) an underlying futures contract when the option is exercised.

Strike Price Ranges

When trading options you can choose from a range of strike prices that are set at predefined intervals by the exchange. The interval range may vary depending on the underlying futures contract.

While futures can trade at prices in between these intervals, the exchange attempts to set the option strike intervals to meet the market’s need for liquidity and granularity.

Each option product will have a unique price interval rule that is based on the product structure and the needs of the market. Not only will products have varying intervals, but also within certain products, the intervals will change depending on the expiration month.

For example, options on corn futures have an interval of 5 cents for the two front months, of the expiring futures contract and then transition to 10 cent intervals for contracts 3 months and beyond.

The full range of strike prices, for many options products, will be determined by the previous day’s daily settlement price for the futures contract.

Over time the entire range may expand beyond the initial listed boundaries, due to large market movements. In addition, strike intervals can become more granular as options move closer to expiration.

Example Strike Price Range

In our example we are going to look at a fictional contract with a December expiration. At outset of the option contract, the price rule dictates a 10 point interval and a 40 point range. Assume the underlying futures contract is trading around 100 points, the option price range will be set at 80, 90, 100, 110, and 120.

As the price of the underlying futures contract moves, the exchange will monitor and adjust the range of strike prices.

After the first quarter the futures market fell to 83 points, therefore another strike price at 70 was made available.

In the third quarter the futures contract rallied higher. The option contracts are now much closer to expiration and have increasing trading activity. To meet demand, additional strike prices at one point intervals are made available between 80 and 100.

By the last quarter the market continued upward and additional one point intervals were needed between 100 and 110.

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Peter Knight Advisor

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Option Expiration Dates

Options do not last forever.  They expire or terminate; they all have an ending date.

Options are tied to an underlying futures product and all futures products have a settlement date. If the futures contract no longer exists, then clearly an option on that contract can no longer exist either.

When do options expire?

When it comes to options on futures, there may be a variety of option expiration dates you could trade for the same futures contract.

You may find some option expirations align with the expiration of the underlying futures contract. In other cases a futures product could have a variety of shorter term options listed. These shorter term options offer traders greater precision and flexibility to expand their trading strategies.

Expiration Examples

Assume the E-mini S&P 500® futures contract (ES) has a settlement date in June.

Quarterly Options

Quarterly options contracts are offered on the E-mini S&P 500® futures contract. In this case the June quarterly option contract would expire at the same time as the futures contract.

Monthly Options

Monthly contracts are also offered for the same futures product. With a monthly option contract you can express a short term opinion on this longer dated futures contract.

For each listed month, such as May and April, you can trade an option that will expire within a month and settles into the same June ES futures contract.

Weekly Options

If your time horizon is even shorter, there are weekly options on the E-mini S&P 500 futures contract.

A rolling list of five weekly options that expire each Friday is offered on most products. After each weekly front-end contract expires, another back-end weekly is listed.

Physically Delivered Commodity Options

When it comes to physically-delivered commodities, option expirations will expire prior to the futures settlement. This happens so that traders have an opportunity to mitigate delivery of the physical product.

For example, when WTI Crude Oil futures settle in June, the WTI option will have a May expiration date. If the option is exercised into the active futures contract, the trader has time to adjust their futures position to either offset the position or make plans to take delivery.

Summary

Options can have a variety of option expiration dates, giving you the flexibility to find a product that meets your trading needs.

For more information on specific option expirations, visit the product specification pages on cmegroup.com.

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

Regards,
Peter Knight Advisor

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Option contracts are written on a broad cross section of underlying futures contracts. Since 1982, when option contracts on futures were first introduced, the options market has grown significantly and now most major US futures contracts have companion option contracts. Very few new futures contracts are listed on major exchanges without an associated option contract. Hedgers and speculators alike spend a great deal of time examining price behavior unique to each underlying futures contract. Historic price data along with other statistics, such as open interest, volatility, delta, etc., are useful in choosing the strike price and time frame for an option contract.

CME Group is the world’s largest Derivatives Exchange. In 2016, average daily volume reached a record 15.6 million contracts and open interest exceeded a record 120 million contracts.

Both futures and options on futures are called derivatives because they “derive” their value from something other than themselves. For example, a corn futures contract derives its value from the actual underlying corn that can be delivered into the contract.

An option on a future is no different in this regard, but the underlier is another derivative, namely the corn future, which in turn has actual corn as its underlier.

Option contracts span a variety of asset classes, including Interest Rates, Equity Indexes, Foreign Exchange, and physical commodities.

Each option you hold is either the right to buy (call option) or the right to sell (put option) an underlying futures contract as defined by the name of the underlying commodity, index, or interest rate future on which the option is based.

For example; 

If you are holding a Gold option on a commodity future, you will have the opportunity to either buy, in the case of a call, or sell, in the case of a put, a Gold futures contract at a specific price on or before the expiration of that contract.

If you are holding an S&P 500® Equity Index option, then you have the opportunity to either buy or sell a future, at a specified price, on the S&P 500®-index level for a defined period of time.

When holding a Treasury option, you have the right to buy or sell a $100,000 US Treasury bond futures contract at a specific price during a certain period of time.

In each case, the underlying contract influences the value of the option: the strike range, the premium, and the timing for each option.

Doing your homework on the underlying futures contract, may help you identify opportunities in the associated options contracts.

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

Regards,
Peter Knight Advisor

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