How Options Work: The Basics of Puts and Calls

May 25, 2018 10:22 AM
 
Let’s stop for a minute and talk the nuts and bolts of options. No ... don’t run screaming and scroll past this! This is painless and it might even help seasoned marketers understand more about options.

Let’s get away from the fundamentals of the grains and talk the nuts and bolts of options. No ... don’t run screaming and scroll past this! This is painless and 
it might even help seasoned marketers understand more about options. Let’s start with a basic description of call and put options.

callA call option is the right, but not the obligation, to establish a long futures position at a specific price.

The definition is much more complicated than reality.

If you buy a $3.50 July corn call, it means you have the right to establish a long position in July futures at $3.50. Of course, you pay for that right (the premium). If July futures rally to $3.80, it makes sense to establish the long position in futures at $3.50, so the call premium increases. If you paid 10¢ for the right to do so, your net entry is $3.60—the strike price plus the premium paid for the call. If you don’t want to be long futures, you can take profits and liquidate the position. In this example, the profit would be about 20¢. The premium of the call option includes three variables: intrinsic value, time value and volatility. Intrinsic value is determined by how close the strike price is to the actual futures price. A $3.50 July call with July futures at $3.60 means the intrinsic value is a dime. The same call option with July futures at $3.40 has no intrinsic value—that’s why it’s referred to as “out-of-the-money.”

Buying a December call option now means you are buying the right to establish a long position for a long period of time; you pay for that time. Buying a July call option now buys a much shorter period of time, lowering the premium.

Volatility is a measure of how much futures prices are moving. Lackluster trade over a period of time sucks volatility out of option premium. Wild price action increases the volatility value.

The relationship of the call option premium to the futures price is like the wings on a bird. When futures rise, so does the premium on a call option. When futures fall, so does the premium on a call option.

A put option is the right, not the obligation, to establish a short futures position at a specific price.

putIf you buy a $3.50 July corn put, you can establish a short position in July futures at $3.50. If July futures fall to $3.20, it makes sense to establish the short position in futures at $3.50, so the put premium increases. If you paid 10¢, your net entry is $3.40—the strike price minus the premium paid for the put. You don’t have the obligation to establish a short position, so you can liquidate the position and take the profit, or about 20¢.
The factors that determine the value of a call option set the premium on a put option. If you own a $3.50 July put option with July futures at $3.40, your put is in-the-money by a dime (intrinsic value). With July futures at $3.60, your put is out-of-the money (intrinsic value is zero)—time and volatility make up the majority of the premium of this put option.

The put option premium relationship to the futures price is a see-saw with futures on one side and the put premium on the other. As the futures price rises, the put premium falls. When futures fall, the put premium rises. That’s why a put option is often called a “price floor.”   

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