Commodity Options

Introduction An option is an contract which gives the buyer of the option the right – but not the obligation - by exercising the option, to require the seller (writer) of the option to perform according to the stated provisions of the contract. In the present case, the “performance” will commonly to provide the owner of the option with a long or short position in the referenced asset (futures contract) at a stipulated price. Option Classes There are two classes of options: call options and put options. Both calls and puts are traded for the same delivery months. Both calls and puts generally trade for the underlying futures contract. Often, options will be listed and have expirations in months other than the listed futures months (e.g. an October expiry Call option that uses the December futures contract as the reference asset). The price paid for a put or call option is called the premium and is established in open competitive trading on the floor of the exchanges trading the options. A call is an option contract in which the buyer pays a premium for the right, but not the obligation, to buy (go long) a commodity futures contract from the seller at an agreed price (strike or exercise price). A put is an option contract in which the buyer pays a premium for the right, but not the obligation, to sell (go short) a commodity futures contract at an agreed price (strike or exercise price). The put and call options can be exercised at any time before the expiration date. Options will be traded on an expiration cycle based on the expiration cycle of the underlying futures contract.

Classification
Options may be grouped into three basic classifications. Type of option means the classification of a option contract as either a put or a call. I!. Class of options means all option contracts of the same type covering the same underlying futures contract, for example, all T-bond call options regardless of the exercise price or expiration date. III. Series of options means all option contracts of the same class with the same exercise price and expiration date, for example, a Comex gold April 400 call.

Buyer’s Rights Versus Seller’s Obligations
“for every buyer there must be a seller” In options trading, an option seller must be prepared to enter a futures position opposite to the option buyer - if the option is exercised, and at a time

etc). . The initial exercise prices will generally bracket the current price of the underlying futures contract of the same expiration month. This is illustrated by the following: Seller (the Writer. For puts. series. Option Premiums The central focus of options trading is the Premium.determined by the option buyer. Listing of New Options When a new option is made available for trading (a new strike. or Short the Option) Buyer (the Purchaser or Long the Option.) Call. An opening transaction establishes or increases a position in an option. Call. they lose all premium and reflect only intrinsic value. If the buyer decides to exercise he will assume a short position in the underlying futures contract. this is the greater of “zero” (worthless) or the market price of the underlying futures contract minus the strike price. And the option seller is said to have been “assigned”. this is the greater of “zero” (worthless) or the strike price minus the market price of the underlying futures contract. The range of the strikes for the initial bracket will generally be about 90 day’s worth of expected price volatility. The process of forcing the option seller to perform on his obligation is called “exercising” the option. A closing transaction is the opposite. Put. Intrinsic value is the amount of money the option is “in the money”. Meaning: at expiration. Opening and Closing Transactions All options transactions are either opening or closing transactions. If the buyer decides to exercise he will assume a long position in the underlying futures contract. additional strike prices will be listed for trading by the exchange. it is said to be “listed”. The writer will be assigned a short futures position if the buyer exercises his option. The writer will be assigned a long futures position if the buyer exercises his option. Put. An opening transaction may be a sale (shorting the option) or a purchase (buying the option). Options are wasting assets. As future prices fluctuate. For calls.

IN-the-money = a positive intrinsic value AT-the-money = the strike price and the market price are the same OUT-of-the-money = a negative intrinsic value Note: When determining whether a put or call option is in-the-money or out-of-the-money. Premiums for options on U. the intrinsic value is the amount of the premium by which the futures price is above the option’s strike price (exercise price). is referred to as time value. Intrinsic Value Revisited For a call option. it is always from the long’s perspective. it is important to have a firm grasp of how option premiums are determined and the dominant factors that impact the premium (price).S.For both puts and calls.25 per contract). Generally. is that they are determined by supply and demand between buyers and sellers. For example. Treasury bond futures are quoted in points and 64ths of a point ($15. The amount of time value depends not only on the “in/at/out” of the money – but has a large dependency on how much time is left until the option expires. The longer the time to expiration. the greater the time value will be. Treasury bond futures are quoted in points and 32nds of a point ($31. Thus. . This decision is entirely the right of the long (not the short). greater than the option’s intrinsic value. The premium is the market price of a particular option at a particular time.S. the time value portion of an option’s premium will diminish with the passage of time. an option with three-months until expiration will usually trade at a higher premium than one with three weeks left and the same exercise price. (for most of the test’s purposes. Time Value The part of an option’s price (its PREMIUM). Example: Option Premiums for CMEgroup / CBT T-Bond Futures U. it is the long’s right (not obligation) to exercise the option and acquire a futures market position. assume this is a fact) Special Note: Options prices are frequently quoted in price increments different than the underlying instrument (futures) Care must be taken to understand the ‘tick value’ (the minimum price fluctuation) for both.625 per option). The first thing to remember about option premiums. The exact price that buyers and sellers are willing to accept at a particular time is influenced by two primary factors: the intrinsic value and the time value of the option.

25) is to improve “delta management”.625 vs $31. there is never a margin call and the entire risk is the premium. the purchase of calls presents a method of entering markets with a limited risk. It is used to estimate the change in the option price for a stated change in the futures price. but the common theme is to take advantage of an expected increase in the price of an underlying futures contract. Buying Calls Traders buy calls for many reasons. $15. Calls to Protect Anticipated Purchases (User Hedging) Commercial and institutional users may use options as insurance to reduce market exposure when planning large purchases of specific commodities or financial instruments.g. Expiration Date This is the last day that the option may be exercised. The delta of the option moving into-the-money (out-of-the-money) increases (decreases). Options Terms Strike (Exercise) Price This is the price at which the buyer of the call may exercise his right to purchase the underlying futures contract. In the case of the put option. The “delta” is the change in the price of an option for a given change in the underlying futures price. If the market declines. If the market continues to rise. Common Examples: Calls for Limited Risk / Limited Return Speculation in Rising Markets If futures are rising. Calls to Hedge Short Futures Positions A trader can buy calls to protect existing short positions or partially mitigate risk from short futures positions.The common reason why some options have a smaller tick increment (e. Buying Puts A trader can effect the same strategies in PUTS – but to protect the opposite risks (or express the opposite speculative positions) Writing (Selling) Calls A call writer (seller) agrees to sell: . the calls can be resold or exercised at a profit. it is the price at which the buyer of the put may exercise his right to sell the underlying futures contract.

Covered call writers generally think of their strategy as ‘conservative’ since they seek to reduce the risk of their existing long futures positions or to gain another source of income (the premium).a given futures contract at the specific strike (exercise) price at any time prior to expiration as determined by the option long. therefore. (1 futures position + 1 long options position = 1 synthetic long option position) Synthetic Long Call To replicate a Long Call using a synthetic position (created from a futures position and an options position): Buy one Futures contract and buy one Put option with a Strike identical to the purchase price of the futures contract. Writing (Selling) Puts A trader can effect the same strategies in PUTS – but to protect the opposite risks (or express the opposite speculative positions) Constructing Synthetic Positions A synthetic option position is the use of an options position and a futures position that has the same effect of one – different .long option position. unlimited risk. Uncovered (Naked) Call Writers Those who have no underlying futures position are uncovered call writers. the writer is assigned a short futures position at the strike price of the option. Ifthe call option is exercised by the buyer. To compensate for taking on this obligation. the call writer receives compensation from the call buyer in the form of the premium. Uncovered call writers seek to gain from an expected weakening of the underlying futures. a large net loss could result. attempting to capture the premium that motivates call writers to participate in the market. Covered Call Writers Those who own the underlying futures are covered call writers. The long futures contract in the covered-call-writer’s portfolio functions to cover the unwanted ‘short position’ if the option is exercised by a call buyer. theoretically. There is. Much like an insurance company selling you accident insurance. The risks involved with writing calls are greater than those for buying calls. . It is. The risk of naked call writing stems from the possibility that if the futures price increases significantly and the call is assigned.

Maximum risk = the premium paid for the Call +/.Maximum risk = the premium paid for the Put +/. Spreading with Options An option spread is the purchase of one or more option contract(s) and selling the same number of option contracts in a different series of the same class of options.any difference between actual price you were able to buy the futures (since it is unlikely you bought the futures at exactly the strike price) and the strike price for the Put Maximum profit = unlimited What we have constructed is called a synthetic long Call. .any difference between actual price you were able to sell the futures (since it is unlikely you sold the futures at exactly the strike price) and the strike price for the Call Maximum profit = unlimited (at least down to ‘zero’ price of the underlying) What we have constructed is called a synthetic long Put. Synthetic Futures A synthetic futures position is an option position with the same profit / loss profile as a long or short position in the futures market. A synthetic long (short) futures position would be long a call (put) option and short a put (call) option. A synthetic long put = long call + short futures. Synthetic Long Put To replicate a Long Put using a synthetic position (created from a futures position and an options position): Sell one Futures contract and buy one Call option with a Strike identical to the sale price of the futures contract. A synthetic long call = long put + long futures. Synthetic Short Call A synthetic short call is a short T-bond put option and a short T-bond futures contract. Note: Compare / contrast Synthetic short calls and synthetic short puts to ‘covered options’. Traders generally try to time the purchase and sale to be “simultaneous” or nearly so. Synthetic Short Put A synthetic short put is a short gold futures call option and a long gold futures contract. The term “net spread” refers to the difference in premiums between the purchase and the sale.

Vertical spread = different exercise price + same expiration dates Bullish Call Spread A bullish (or simply “bull”) call spread is a vertical spread where the trader purchases the lower strike call option and sells the higher strike call option This will always result in a debit transaction because the lower exercise price will have the higher premium. A trader would sell a vertical bull put (credit) spread to generate net credits and because he is neutral to bullish. If the long position has a lower premium than the short position. he is bullish but not wildly bullish). Bull Put Spread The bull put spread is a vertical spread where the trader buys a put option with the lower exercise price and sells a put option with a higher exercise price.If the long position has a higher premium than the short position. Calendar Spreads A calendar spread is the purchase and sale of options of the same class with the same exercise prices but with different expiration dates. The net will be a credit transaction since the lower strike will have the higher premium. Calendar spread = same exercise price + different expiration dates. the investor would be required to pay the difference in premiums. However. This would be called a debit spread. A trader sells a bear call spread to generate a net credit and because he is neutral to bearish. this is the same action that a bull call spreader would take. the put spread will be a credit transaction because the higher exercise price (for PUTS) will have the higher premium. Bear Put Spread . the investor would be generally be allowed to withdraw (or at least earn interest on) the difference in premiums. Vertical Spreads A vertical spread is the purchase and sale of options of the same class with the same expiration date but with different exercise prices. Bear Call Spread A bearish (or simply “bear”) call spread is the sale of a low strike call option the purchase of a higher strike call option. Also called a time or horizontal spread. The trader would buy a vertical bull call (debit) spread because he wishes to target a particular range of prices (e. Interestingly.g. This would be called a credit spread. Also called a money or price spread.

this is the same action that a bear call spreader would take. Bull Put Spread Buy the put with the lower exercise price and sell the put with the higher exercise price. Again. Summary Traders who are bullish on the market will either buy a bull call spread or sell a bull put spread. it is a position in BOTH a Put and a Call with everything else the same. Traders who are bearish on the market will either buy a bear put spread or sell a bear call spread. Opposite Spreads vertical bull (debit) call spread // vertical bear (credit) call spread vertical bull (credit) put spread // vertical bear (debit) put spread The trader buys vertical debit spreads and sells vertical credit spreads. Bull Call Spread Buy the call with the lower exercise price and sell the call with the higher exercise price. Straddles A straddle is: The purchase (sale) of BOTH a put and a call. The net result is a DEBIT spread. Bear Put Spread Sell the put with the lower exercise price and buy the put with the higher exercise price. The net result is a CREDIT spread. Bear Call Spread Sell the call with the lower exercise price and buy the call with the higher exercise price. on the same underlying instrument (futures) with the same expiration date. Long Straddle . The net result is a DEBIT spread. and the same exercise price. In other words. he is bearish but not wildly bearish). The net result is a CREDIT spread.The bear put spread is the sale a lower strike put option and the purchase of a higher strike put option. with the big difference that the bear call spread and the bear put spread is that the net result of the bear put spread is a debit transaction because the higher exercise price will have the higher premium.g. The trader would buy a vertical bull put (debit) spread because he wishes to target a particular range of prices (e.

at DIFFERENT strike prices. SPAN). the spread is a debit (credit) transaction. However. on the same underlying instrument (futures) with the same expiration date. Her maximum profit is limited to the premium collected. When you pay more (less) for the long option than you receive in premium for the short option.. and . (call above / put below the market). Strangles A strangle is: The purchase (sale) of BOTH a put and a call. The buyer’s risk is limited to the total premiums paid and would be hurt by time delay in a non-volatile or stable market. however .g... Therefore. Potential loss in an option spread is largely due to two factors: strike price . the strikes initially surround the market.. Commonly. Margins on Option Spreads Most current option margins are determined by the relevant Exchange and use dynamic risk-weighting algorithms (e. it is difficult to state ‘general rules’ regarding the amount of margin required for debit spreads. and the risk is unlimited. In general. but he is not sure in which direction. and in general: An option spread is the purchase and sale of two different put or call options. Short Straddle A trader might sell a straddle (sell both parts) if she thinks there will be little or no movement in the price of the underlying futures contract for an extended period of time. a credit spread will require a margin deposit while debit spreads require you to pay in full. Long Strangle A trader may buy a straddle (buy both parts) if she believes the underlying futures contract was going to make a very sizeable move reasonably soon. but she is not sure in which direction.A trader may buy a straddle (buy both parts) if he believes the underlying futures contract was going to make a sizeable move reasonably soon. The potential profit is unlimited (in theory). Short Strangle A trader might sell a straddle (sell both parts) if she thinks there will be little or no movement in the price of the underlying futures contract for an extended period of time.

If the long option expires before the short option. If the strike price of the Long Call is Greater than the strike price of the Short Call. 2. 1. margin is required. If the strike price of the Long Put is Less than the strike price of the Short Put. Here are three somewhat simplified rules for quickly estimating whether margin will be required for specific spreads. .expiration date. 3. margin is required. margin is required.

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