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) Buy

Exercise Long Short

Call

Sell (Writer) Buy

Exercise Short 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 Puts

24.00 4.93 24.00 0.02

25.00 3.97 25.00 0.06
30.00 .35 30.00 1.43
35.00 .05 35.00 6.12
40.00 . 01 40.00 11.09
 Premiums: Puts and Calls 10/31/01
Cotton: Z01 Futures at 29.90 Cents Per Pound

Calls Puts

24.00 5.91 24.00 0.02

25.00 4.93 25.00 0.04
30.00 .68 30.00 .78
35.00 .05 35.00 5.14
40.00 . 01 40.00 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 Puts Premium Intrinsic

Time
24.00 4.93 4.92 .01 24.00 .02
25.00 3.97 3.92 .05 25.00 .06
30.00 .35 .00 .35 30.00 1.43
35.00 .05 .00 .05 35.00 6.12
40.00 . 01 .00 .01 40.00 11.09
10/31 10/31
24.00 5.91 5.90 .01 24.00 .02
25.00 4.93 4.90 .03 25.00 .04
30.00 .68 .00 .68 30.00 .78
35.00 .05 .00 .05 35.00 5.14
40.00 .01 .00 .01 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 Puts Premium Intrinsic

Time
24.00 4.93 4.92 .01 24.00 .02 .00 .02
25.00 3.97 3.92 .05 25.00 .06 .00 .06
30.00 .35 .00 .35 30.00 1.43 1.08 .35
35.00 .05 .00 .05 35.00 6.12 6.08 .06
40.00 . 01 .00 .01 40.00 11.09 11.08 .01
10/31 10/31
24.00 5.91 5.90 .01 24.00 .02 .00 .02
25.00 4.93 4.90 .03 25.00 .04 .00 .04
30.00 .68 .00 .68 30.00 .78 .10 .68
35.00 .05 .00 .05 35.00 5.14 5.10 .04
40.00 .01 .00 .01 40.00 10.11 10.10 .09
 Intrinsic and Time Value:Call
Underlying Futures at $2.80

Strike Price Premium Intrinsic Value Time Value

(Call)
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 Premium Intrinsic Value Time Value

(Put)
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 Options - Buy Put
Price falls - Gain from futures, Price falls- Premium deducted from
no premium N.S.P.
Price rises – Gain from cash Price rises – Let put expire, collect
Price Locked 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
Producer has cost of prodnSelland Buy a July $2.25 put for a premium
July corn fut. at $2.25
storage of $2.20 for delivery by 7/1 of .15

Price Rises
July 1

Sell July corn at $2.35 July puts trading for a premium

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

Price Falls
July 1

Sell July corn at $2.00 Buys July futures @ $2.00July $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
Producer has cost of prodnSelland Buy a July $2.25 put for a premium
July corn fut. at $2.25
storage of $2.20 for delivery by 7/1 of .15

Price Rises
July 1

Sell July corn at $2.45 July puts trading for a premium

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

Price Falls
July 1

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
 Long Hedging: Futures vs. Options

Comparison of Futures vs. Options: Long Hedging

Cash Futures Options

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

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

Price Falls
July 1

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

Buyer: Puts Seller (Writer): 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

Let option expire Collect premium

Offset or retrade Offset or retrade

Price Decreases

Exercise: Assigned futures short Assigned futures long

Offset or retrade Offset or retrade
 Options: Call Buyer-Seller Choices

Options

Buyer: Calls Seller (Writer): 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 Collect premium

Offset or retrade 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
@ $2.10 strike prices for $.15 posts $650 margin

Price Increases to $2.35

Option buyer lets options expire December corn futures rises to $2.35
Writer has premium of $.15 Writer buys corn futures @ $2.35

Net to Writer

$.15 premium
-.25 loss in futures
-.01 futures commission
-.01 interest
-.12 loss
 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 Buys December Corn futures @ $2.10
@ $2.10 strike prices for $.15 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 Buys December Corn futures @ $2.10
@ $2.10 strike prices for $.15 posts $650 margin

Price Decreases to $2.00

Buyer lets option expire December corn futures fall to $2.00

Writer has premium of $.15 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
@ $2.10 strike prices for $.15 Writer has no futures position

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
Options writer sells a call on Dec. December
Corn corn futures @ $2.10
@ $2.10 strike prices for $.15 writer has no futures position

Price Increases to $2.35

Buyer exercises option December corn futures rises to $2.35

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
Options writer sells a call on Dec. December
Corn corn futures @ $2.10
@ $2.10 strike prices for $.15 writer has no futures position

Price Falls to $2.00

Buyer lets options expire December corn futures falls to $2.00

Seller (writer) has premium of $.15

Net to Writer (Exc. int., other)

+ $.15 premium
 Writing Options: Summary

Covered and Naked Options Writing

Price Increase Price Decrease

Writer Naked Covered Naked Covered

Puts Gains Unlimited Unlimited Gains

premium Loss Pot. Loss Pot. premium

Calls Unlimited Gains Gains Unlimited

Loss Pot. premium premium Loss Pot.

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

in all cases