1. Introduction
2. Option Terms
3. Why Use Options
4. Option Valuation
5. Motives for Buying and Selling Options
   • Buying Calls
   • Selling Calls
   • Buying Puts
   • Selling Puts
6. Futures Positions after Option Exercise
7. Option Premium Valuation
   • Price Value
   • Time Value
   • Volatility

INTRODUCTION

Options on futures contracts have added a new dimension to futures trading. The principal attraction of buying options is that they make it possible to speculate on increasing or decreasing futures prices with a known and limited risk. The most that the buyer of an option can lose is the cost of purchasing the option (known as the option "premium") plus transaction costs. Like futures, they provide price protection against adverse price moves.

Who sells the options that option buyers purchase? The answer is that options are sold by other market participants known as option writers, or grantors. Their sole reason for writing options is to earn the premium paid by the option buyer. If the option expires without being exercised (which is what the option writer hopes will happen), the writer retains the full amount of the premium. If the option buyer exercises the option, however, the writer must pay the difference between the market value and the exercise price. It should be emphasized and clearly recognized that unlike an option buyer who has a limited risk (the loss of the option premium), the writer of an option has unlimited risk. This is because any gain realized by the option buyer if and when he exercises the option will become a loss for the option writer.

Present-day options trading on the floor of an exchange began in April 1973 when the Chicago Board of Trade created the Chicago Board Options Exchange (CBOE) for the sole purpose of trading options on a limited number of New York Stock Exchange-listed equities. Options on futures contracts were introduced at the CBOT in October 1982 when the exchange began trading Options on U.S. Treasury Bond futures.

OPTIONS TERMINOLOGY

There are several important terms the would-be user of options on futures should understand. They include:

call option:

Gives the buyer the right, but not the obligation, to buy a specific futures contract at a predetermined price within a limited period of time.

put option:

Gives the buyer the right, but not the obligation, to sell a specific futures contract at a predetermined price within a limited period of time.

holder:

The buyer of the option.

premium:

The dollar amount paid by the buyer of the option to the seller.

writer:

The option seller.

strike price:

The predetermined price at which a given futures contract can be bought or sold. Also called the exercise price, these levels are set at regular intervals. For example, if Treasury bond futures were at 79-00, T-bond option strike prices would be at 74, 76, 78, 80, 82, and 84.

at-the-money:

An option is at-the-money when the underlying futures price equals, or nearly equals, the strike price. For example, a T-bond put or call option is at-the-money if the option strike price is 78 and the price of the Treasury bond futures contract is at, or near, 78-00.

in-the-money:

A call option is in-the-money when the underlying futures price is greater than the strike price. For example, if Treasury bond futures are at 80-00 and the T-bond call option strike price is 78, the call is in-the-money. The put option is in-the-money when the strike price of the option is greater then the price of the underlying futures contract. For example, if the strike price of the put option is 80 and T-bond futures are trading at 77-00, the put option is in-the-money.

out-of-the-money:

A call option is out-of-the-money if the strike price is greater than the underlying futures price. For example, if T-bond futures are at 80-00 and the T-bond call option has an 82 strike price, the option is out-of-the-money. The put option is out-of-the-money if the underlying futures price is greater then the strike price. For example, if T-bond futures are at 77-00, and the T-bond put option strike price is 76, the put option is out-of-the-money.

Options are considered "wasting assets." In other words, they have a limited life because each expires on a certain day, although it may be weeks, months, or years 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.

If an option position is covered, the seller holds an offsetting position in the underlying commodity itself or a futures contract. For example, the seller of a Treasury bond call option would be covered if he actually owned cash market U.S. Treasury bonds or was long the Treasury bond futures contract.

If the writer did not hold either, he would have an uncovered or "naked" position. In such instances, margin would be required because the seller would be obligated to fulfill terms of the option contract in the event the contract is exercised by the buyer. It is imperative, therefore, that the seller demonstrate the ability to meet any potential contractual obligations beforehand. In addition, the seller of uncovered options on interest rate futures assumes the potential for significant losses.

MOTIVES FOR BUYING AND SELLING OPTIONS

One may be a buyer or seller of call or put options for a variety of reasons.

• Buying Calls

The buyer of a call option acquires the right but not the obligation to purchase (go long) a particular futures contract at a specified price at any time during the life of the option. Each option specifies the futures contract which may be purchased (known as the "underlying" futures contract) and the price at which it can be purchased (known as the "exercise" or "strike" price). A March Treasury bond 84 call option would convey the right to buy one March U.S. Treasury bond futures contract at a price of $84,000 at any time during the life of the option.

A call option buyer is bullish. That is, he or she believes the price of the underlying futures contract will rise. A call option buyer will realize a net profit if, upon exercise, the underlying futures price is above the option exercise price by more than the premium paid for the option. Or a profit can be realized it, prior to expiration, the option rights can be sold for more than they cost.

To summarize, there are three courses of action available.

1. to exercise the option and acquire the underlying futures contract at the strike price.
2. The second is to offset the long call position with a sale and realize a profit.
3. The third, and least acceptable, is to let the option expire worthless and forfeit the unrealized profit.

Example: You expect lower interest rates to result in higher bond prices (interest rates and bond prices move inversely). To profit if you are right, you buy a June T-bond 82 call. Assume the premium you pay is $2,000. If, at the expiration of the option (in May) the June T-bond futures price is 88, you can realize a gain of 6 (that's $6,000) by exercising or selling the option that was purchased at 82. Since you paid $2,000 for the option, your net profit is $4,000 less transaction costs. As mentioned, the most that an option buyer can lose is the option premium plus transaction costs. Thus, in the preceding example, the most you could have lost--no matter how wrong you might have been about the direction and timing of interest rates and bond prices--would have been the $2,000 premium you paid for the option plus transaction costs.

In contrast if you had an outright long position in the underlying futures contract, your potential loss would be unlimited. It should be pointed out, however, that while an option buyer has a limited risk (the loss of the option premium), his profit potential is reduced by the amount of the premium. In the example, the option buyer realized a net profit of $4,000. For someone with an outright long position in the June T-bond futures contract, an increase in the futures price from 82 to 88 would have yielded a net profit of $6,000 less transaction costs. Although an option buyer cannot lose more than the premium paid for the option, he can lose the entire amount of the premium. This will be the case if an option held until expiration is not worthwhile to exercise.

• Selling Calls

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. For instance, if T-bond futures were purchased at 80-00 and a call option with an 80 strike price was sold for 2-00, T-bond futures could decline to the 78-00 level before there would be a net loss in the position (excluding, of course, margin and commission requirements).

However, should T-bond futures rise to 82-00, the call option seller forfeits the opportunity for profit because the buyer would likely exercise the call against him and acquire a futures position at 80-00 (the strike price).

• Buying Puts

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. As in the case of call options, the most that a put option buyer can lose, if he is wrong about the direction or timing of the price change, is the option premium plus transaction costs. For example, if a T-bond put option with a strike price of 82 is purchased for 2-00, while T-bond futures also are at 82-00, the put option will be profitable for the purchaser to exercise if T-bond futures decline below 80-00.

In many instances, puts will be purchased in conjunction with a long cash or long T-bond futures position for "insurance" purposes. For instance, if an institution is long T-bond futures at 82-00 and a T-bond put option with an 82 strike is purchased for 2-00, the futures contract could, theoretically, fall to zero and the put option holder could exercise the option for the 82 strike price, assuming the option had not yet expired.

Another Example: Expecting a decline in the price of gold, you pay a premium of $1,000 to purchase an October 320 gold put option. The option gives you the right to sell a 100 ounce gold futures contract for $320 an ounce. Assume that, at expiration, the October futures price has--as you expected-declined to $290 an ounce. The option giving you the right to sell at $320 can thus be sold or exercised at a gain of $30 an ounce. On 100 ounces, that's $3,000. After subtracting $1,000 paid for the option, your net profit comes to $2,000. Had you been wrong about the direction or timing of a change in the gold futures price, the most you could have lost would have been the $1,000 premium paid for the option plus transaction costs. However, you could have lost the entire premium.

• Selling Puts

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. The chart below illustrates what happens to the buyer and the seller after an option is exercised.

FUTURES POSITIONS AFTER OPTION EXERCISE

OPTION PREMIUM VALUATION

Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers. Major variables influence the premium for a given option.