Options

Options: Basic Definitions “Put” option gives the buyer the right to a short position in the futures market. Seller or writer of the put is assigned a long position IF the option is exercised “Call” option give the buyer the right to a long position in the futures market. Seller or writer of the call is assigned a short position IF the option is exercised

Calls and Puts Put Sell (Writer) Exercise

Long

Buy Short

Call Sell (Writer) Exercise

Short

Buy Long

Definitions • • • • •

“Strike Price” Specific price owner has right to buy or sell “Premium” Cost of buying an option at a particular strike price “In the Money” Put—futures is below strike price “In the Money” Call—futures is above strike price “Intrinsic Value” Difference between the underlying futures and an in the money put or call • “Time Value” Difference between options premium and intrinsic value

Premiums: Puts and Calls 10/30/01 Cotton: Z01 Futures at 28.92 Cents Per Pound Calls 24.00 25.00 30.00 35.00 40.00

Puts 4.93 3.97 .35 .05 . 01

24.00 25.00 30.00 35.00 40.00

0.02 0.06 1.43 6.12 11.09

Premiums: Puts and Calls 10/31/01 Cotton: Z01 Futures at 29.90 Cents Per Pound Calls 24.00 25.00 30.00 35.00 40.00

Puts 5.91 4.93 .68 .05 . 01

24.00 25.00 30.00 35.00 40.00

0.02 0.04 .78 5.14 10.11

Change in Intrinsic and Time Value: Question Cotton: Z01 Futures at 28.92 Cents Per Pound on 10/30 And 29.90 Cents Per Pound on 10/31 Calls Premium Intrinsic Time 24.00 25.00 30.00 35.00 40.00 24.00 25.00 30.00 35.00 40.00

4.93 3.97 .35 .05 . 01 10/31 5.91 4.93 .68 .05 .01

4.92 3.92 .00 .00 .00

.01 .05 .35 .05 .01

5.90 4.90 .00 .00 .00

.01 .03 .68 .05 .01

Puts Premium Intrinsic Time 24.00 .02 25.00 .06 30.00 1.43 35.00 6.12 40.00 11.09 10/31 24.00 .02 25.00 .04 30.00 .78 35.00 5.14 40.00 10.11

Change in Intrinsic and Time Value: Answer Cotton: Z01 Futures at 28.92 Cents Per Pound on 10/30 And 29.90 Cents Per Pound on 10/31 Calls Premium Intrinsic Time 24.00 25.00 30.00 35.00 40.00 24.00 25.00 30.00 35.00 40.00

4.93 3.97 .35 .05 . 01 10/31 5.91 4.93 .68 .05 .01

4.92 3.92 .00 .00 .00

.01 .05 .35 .05 .01

5.90 4.90 .00 .00 .00

.01 .03 .68 .05 .01

Puts Premium Intrinsic Time 24.00 .02 .00 25.00 .06 .00 30.00 1.43 1.08 35.00 6.12 6.08 40.00 11.09 11.08 10/31 24.00 .02 .00 25.00 .04 .00 30.00 .78 .10 35.00 5.14 5.10 40.00 10.11 10.10

.02 .06 .35 .06 .01 .02 .04 .68 .04 .09

Intrinsic and Time Value:Call Underlying Futures at $2.80 Strike Price (Call)

Premium

Intrinsic Value

Time Value

2.60

.25

.20

.05

2.70

.16

.10

.06

2.80

.10

0

.10

2.90

.07

0

.07

3.00

.05

0

.05

Intrinsic and Time Value: Put Underlying Futures at $2.80 Strike Price (Put)

Premium

Intrinsic Value

Time Value

2.60

.05

0

.05

2.70

.07

0

.06

2.80

.10

0

.10

2.90

.16

.10

.06

3.00

.25

.20

.05

Futures and Options: Hedging Differences Futures- Sell Short Price falls - Gain from futures, no premium Price rises – Gain from cash Price Locked

Options - Buy Put Price falls- Premium deducted from N.S.P. Price rises – Let put expire, collect price differential over premium cost Price not locked on upside

Price Falls: Zero Basis Futures Sell $7.00 Futures and Price Falls to $6.50 Gain of $.50 in Futures Loss $.50 in Cash Net selling price $7.00 Put Buy $7.00 put for $.15 premium and price falls to $6.50. Offset put for $.60 premium Loss of $.50 in cash, gain of $.45 on options Net selling price $6.95

Price Rise: Zero Basis Futures Sell $7.00 Futures and Price Rises to $7.50 Gain of $.50 in Cash Loss of $.50 in Futures Net selling price $7.00 Put Buy $7.00 put for $.15 premium and price rises to $7.50. Let put expire Gain of $.50 in cash market Less $.15 premium Net selling price $7.35

Short Hedging: Futures vs. Options

Comparison of Futures vs. Options: Short Hedging Cash

Futures

Options

April 1 Buy a July $2.25 put for a premium Producer has cost of prodn Selland July corn fut. at $2.25 of .15 storage of $2.20 for delivery by 7/1 Price Rises

July 1 July puts trading for a premium Buy July futures @ $2.35 of $.00. ..Let put expire for a cost - $.10 of .15 Net price: futures hedge = $2.20 + .15 - .10 = $2.25 Net price: options hedge = $2.20 +.15 - .15 = $2.20

Sell July corn at $2.35

July 1

Price Falls

Sell July corn at $2.00 Buys July futures @ $2.00 July $2.25 puts trading for + $.25 $.30..net = $.15 premium diff in offset ($.30 - $.15 Net price: futures hedge = $2.20 - .20 + .25 = $2.25 Net price: options hedge = $2.20 - .20 + .15 = $2.15

Short Hedging: Futures vs. Options Price Rise Greater Than Premium

Comparison of Futures vs. Options: Short Hedging Cash

Futures

Options

April 1

Buy a July $2.25 put for a premium Producer has cost of prodn Selland July corn fut. at $2.25 of .15 storage of $2.20 for delivery by 7/1 Price Rises

July 1 July puts trading for a premium Buy July futures @ $2.45 of $.00. ..Let put expire for a cost - $.10 of .15 Net price: futures hedge = $2.20 + .25 - .20 = $2.25 Net price: options hedge = $2.20 +.25 - .15 = $2.30

Sell July corn at $2.45

Price Falls

July 1

Buys July futures @ $2.00 July $2.25 puts trading for + $.25 $.30..net = $.15 premium diff in offset ($.30 - $.15 Net price: futures hedge = $2.20 - .20 + .25 = $2.25 Net price: options hedge = $2.20 - .20 + .15 = $2.15

Sell July corn at $2.00

Long Hedging: Futures vs. Options Comparison of Futures vs. Options: Long Hedging Cash

Futures

Options

April 1 Buy a July $2.25 call for a premium Commercial forward sellsBuy corn July corn fut. at $2.25 of .15 at $2.30 for delivery by 7/1 Price Rises

July 1 July calls trading for a premium Buy July corn at $2.35 Sell July futures @ $2.35 of $.23...sell call for $.23 + $.10 net = $.23 -.15 = + $.08 Net price: futures hedge = $2.30 - .05 + .10 = $2.35 Net price: options hedge = $2.30 - .05 + .08 = $2.33

July 1

Price Falls

Buy July corn at $2.00 Sell July futures @ $2.00 July $2.25 calls trading for - $.25 $.00...Let expire net = -$.15 premium Net price: futures hedge = $2.30 + .30 - .25 = $2.35 Net price: options hedge = $2.30 + .30 -.15 = $2.45

Options: Put Buyer-Seller Choices

Options

Seller (Writer): Puts

Buyer: Puts

1) Exercise the option 1) Hold option till buyer either exercises or lets exp 2) Let the option expire 2) Offset or retrade 3) Sell the option (offset or retrade) Price Increases

Collect premium Offset or retrade

Let option expire Offset or retrade

Price Decreases Exercise: Assigned futures short Offset or retrade

Assigned futures long Offset or retrade

Options: Call Buyer-Seller Choices

Options

Seller (Writer): Calls

Buyer: Calls

1) Exercise the option 1) Hold option till buyer either exercises or lets exp 2) Let the option expire 2) Offset or retrade 3) Sell the option (offset or retrade) Price Increases

Exercise: Assigned futures long Assigned futures short Offset or retrade Offset or retrade Price Decreases Let option expire Offset or retrade

Collect premium Offset or retrade

Options: Calls- Retrade

Retrading Action Individual buys a corn call at $2.10 for $.15

Current price is $2.10

Price Increases to $2.35 $2.10 call price premium rises to $.25 December corn futures rises to $2.35 Individual sells the $2.10 strike price for $.25 Net is $.25- .15 -.01 brokerage fee - int. 01 = $.08 Price Decrease to $2.00

$2.10 call price premium falls to $.05 Futures fall to $2.00 Individual sells the $2.10 strike price for $.05 Net is $.05 - .15 -.01 brokerage fee - int. 01 = -$.12

Options: Calls-Exercising Option

Exercising the Option Action Current price is $2.10 Individual buys a Dec. corn call at $2.10 for $.15

Price Increases to $2.35 Individual exercises the call option and receives a buy corn futures rises to $2.35 December position for the Dec. futures market at $2.10. Posts margin of $650. Sells corn futures to offset for $2.35

+ $.25 per bushel on futures .15 premium .01 brokerage fee - . 01 intererst cost ____ .08 net

Options: Covered Options

Summary Considerations Buyer: Puts

Seller (Writer): Puts

1) Exercise the option if price falls 1) Hold option till buyer either exercises or lets e 2) Let the option expire if price 2) rises Offset or retrade 3) Sell the option (offset or retrade)

Buyer: Calls

Seller (Writer): Calls

1) Exercise the option if price rises 1) Hold option till buyer either exercises or lets e 2) Let the option expire if price falls 2) Offset or retrade 3) Sell the option (offset or retrade) Action in Following Examples 1) We will use the same premium values for puts and calls for ease of arithmetic calculation only 2) We will use the same arithmetic values for price increases and decreases..as well as the same commodity (corn) 2) We will ignore the retrading or offsetting option and consider the end result of call or put exercises

Writing Covered Puts w/Price Increase

Covered Option (Sell) Action Options writer sells a corn put on Dec. Corn Sells December Corn futures @ $2.10 posts $650 margin @ $2.10 strike prices for $.15 Price Increases to $2.35 Option buyer lets options expire Writer has premium of $.15

Net to Writer

$.15 premium -.25 loss in futures -.01 futures commission -.01 interest -.12 loss

December corn futures rises to $2.35 Writer buys corn futures @ $2.35

Writing Covered Puts w/Price Decrease Options: Choices

Covered Option (Sell) Action Options writer sells a corn put on Dec. Corn Sells December Corn futures @ $2.10 @ $2.10 strike prices for $.15 posts $650 margin Price Decreases to $2.00

Buyer exercises receives sellers short position Writer transfers futures to buyer, no gain Writer has gain in value of premium of $.15 to writer Net to Writer (excluding int.

$.15 premium

Writing Covered Calls w/ Price Increase

Covered Call Option (Buy) Action Options writer sells a call on Dec. Corn @ $2.10 strike prices for $.15

Buys December Corn futures @ $2.10 posts $650 margin

Price Increases to $2.35

Option buyer exercises option, receives sellers December corn futures rises to $2.35 long position Writer has transferred ownership of $2.1 Writer has profit of premium of $.15 long to buyer, thus no futures gain Net to Writer (Exc. int.

$.15 premium

Writing Covered Calls w/Price Decrease

Covered Call Option (Buy) Action Options writer sells a call on Dec. Corn @ $2.10 strike prices for $.15

Buys December Corn futures @ $2.10 posts $650 margin

Price Decreases to $2.00

Buyer lets option expire Writer has premium of $.15

December corn futures fall to $2.00 Writer offsets futures by selling Dec Corn futures at $2.00 or a $.10 loss

Net to Writer (Exc. int. Other

$.15 premium .10 loss in futures +.05 profit

Writing Naked Puts w/ Price Increase

Naked Option (Sell) Action December Corn futures @ $2.10 Options writer sells a put on Dec. Corn Writer has no futures position @ $2.10 strike prices for $.15 Price Increases to $2.35

Buyer lets options expire December corn futures rises to $2.35 Seller (writer) has premium of $.15 Net to Writer (Exc. int., other)

$.15 premium

Writing Naked Puts w/Price Decrease

Naked Option (Sell) Action Options writer sells a put on Dec. December Corn Corn futures @ $2.10 @ $2.10 strike prices for $.15 Writer has no futures position Price Decreases to $2.00

Buyer exercises option

December corn futures falls to $2.00

Clearing corp. puts seller long and buyer short @ $2.10 Writer offsets by selling futures for a loss of $.10 Net to Writer (Exc. int. other)

$.15 premium - $.10 loss on futures = $.05

Writing Naked Calls w/Price Increase

Naked Option (Call) Action corn futures @ $2.10 Options writer sells a call on Dec. December Corn writer has no futures position @ $2.10 strike prices for $.15 Price Increases to $2.35

December corn futures rises to $2.35 Buyer exercises option Clearing corporation puts seller short and buyer long Writer offsets by selling futures for a loss of $.25 Net to Writer (Exc. int., other)

+ $.15 premium - . 25 futures loss - $.15 Net loss

Writing Naked Calls w/Price Decrease

Naked Option (Call) Action corn futures @ $2.10 Options writer sells a call on Dec. December Corn writer has no futures position @ $2.10 strike prices for $.15 Price Falls to $2.00 December corn futures falls to $2.00 Buyer lets options expire Seller (writer) has premium of $.15 Net to Writer (Exc. int., other)

+ $.15 premium

Writing Options: Summary

Covered and Naked Options Writing Price Increase

Writer

Naked

Covered

Unlimited Loss Pot.

Puts

Gains premium

Calls

Unlimited Gains Loss Pot. premium

Price Decrease

Naked

Covered

Unlimited Gains Loss Pot. premium Gains premium

Unlimited Loss Pot.

If no price change occurs, writer's net is the premium in all cases