Derivatives Education

What are Derivatives?

The term derivative is used to refer to the set of financial instruments that includes futures, options and swaps whose value is derived from an underlying asset such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indices such as a stock market index.

Introduction to Options

Options on futures open the door to a host of versatile, economical trading strategies; by using options alone, or in combination with futures contracts, strategies can be found to cover virtually any risk profile, time horizon, or cost consideration.

Options on futures provide:

The ability to hedge cash and futures positions against an adverse price direction without foregoing the benefits of favorable price movements.

The availability of hedging insurance at many different levels of cost and degrees of protection. A means for businesses and investors to act aggressively or conservatively on views about the direction and volatility of prices for energy, precious metals, copper, and aluminum.

Because the underlying instrument of an options contract is a futures contract for a specific commodity, market participants can use options to cover themselves against volatile swings in futures prices, just as futures can be used to protect against volatile moves in the prices of the underlying physical commodities.

What Is An Options Contract?

The price at which the underlying futures contract may be bought or sold is the exercise price, also called the strike price. An options contract affords the right to buy or sell for only a limited period of time; each options contract has an expiration date.

When purchasing options, risk is limited to the investment made, which is premium and all fees paid.

On the opposite side, a seller, or writer of an options contract incurs an obligation to perform, should an options contract be exercised by the purchaser. The writer of a call incurs an obligation to sell a futures contract and the writer of a put has an obligation to buy a futures contract.

OPTIONS RIGHTS AND OBLIGATIONS

CALL

Buyer Seller
Has the right to buy a futures contract at a predetermined price on or before a defined date. Grants right to buyer, so has obligation to sell futures at a predetermined price at buyer's sole option
Expectation: Rising prices Expectation: Neutral or falling prices

PUT

Buyer Seller
Has the right to sell a futures contract at a predetermined price on or before a defined date. Grants right to buyer, so has obligation to buy futures at a predetermined price at buyer's sole option
Expectation: Falling prices Expectation: Neutral or rising prices

In return for the rights they are granted, options buyers pay options sellers a premium. There are four major factors affecting the price of an options contract:

  • The price of a futures contract relative to the options strike price.
  • Time remaining before options expiration.
  • Volatility of underlying futures price.
  • Interest rates.

An options contract is a wasting asset. It has an initial value that declines, or wastes away, as time passes. Depending upon the movement of an options price, the buyer will choose one of three alternatives for terminating an options position:

  • Exercise the options contract.
  • Liquidate it by selling it back on the Exchange.
  • Let it expire.

While liquidation is the most common choice, a small percentage of buyers choose to exercise their options, particularly if their strategy calls for acquiring a long or short futures position at the strike price. The ability to trade in and out of positions is the great advantage of standardized options contracts.

If the futures price does not move far enough for an exercise to be worthwhile, or moves in the opposite direction, buyers can simply let their options contract expire valueless.

Because trading on the Exchange is conducted among anonymous counterparties, when an options contract is exercised, the Exchange randomly assigns an options writer to fulfill the obligation.

As in the futures market, options trading takes place in a primarily open outcry auction market on the Exchange. While the value of futures is tied to the underlying cash commodity through the delivery process, the value of an options contract is related to the underlying futures contract through the ability to exercise the option.

What Is Leverage?

The use of various financial instruments (option or futures contracts) to increase the rate of return from an investment.

Leverage can amplify the potential gain from an investment by initiating a relatively small amount of money for the right to potentially capitalize on a much larger amount of capital or product.

These types of financial instruments however, carry a higher degree of risk.

Leverage can be provided to individual investors by purchasing option contracts. Purchasing option contracts can provide investors unlimited profit potential with a risk limited to the total amount invested.

For an example:

An individual has US$10,000 to invest and wants to speculate on the perception of higher Gold prices to come, therefore you could purchase 10 call option contracts and have the right to capitalize on a leverage amount of 1,000 troy ounces of Gold. In other words each contract that is purchased has a leverage of 100 troy ounces of Gold, therefore a relatively small price gain on Gold futures could potentially amplify an investors return.

Strike Price vs. Futures Price

The most important influence on an option's price is the relationship between the underlying futures price and the option's strike price.

Depending upon futures prices relative to a given strike price, an options contract is said to be at-the-money, in-the-money, or out-of-the-money. An options contract is at-the-money when the strike price is the closest to the price of the underlying futures contract. For example, if the November crude oil futures price is $25 per barrel, the November $25 call and the November $25 put are the at-the-money-options.

An options contract is considered in-the-money when the price of the futures contract is above a call's strike price, or when the futures price is below a put's strike price.

When the October heating oil futures price is 72¢ per gallon, the October 70¢ call is in-the-money. It grants the holder of the options contract the right to buy an October futures contract at 70¢ per gallon even though the market is at 72¢. Therefore, the call is automatically worth at least 2¢ per gallon; and is said to have an intrinsic value of 2¢ per gallon.

A put is in-the-money when the underlying futures price is less than the put's strike price. If the September gold futures contract is $280 per ounce, a September $290 put is in-the-money. It gives the holder of the options contract the right to sell a futures contract at a price of $290 even though the market is trading at $280, giving the options contract an intrinsic value of $10.

When the December natural gas futures price is $5.50 per million British thermal units, the December $5.65 call is out-of-the-money. It grants the holder of the options contract the right to buy a December futures contract at $5.65 per million Btus even though the market is at $5.50. Therefore, the call has no intrinsic value.

A put is out-of-the-money when the underlying futures price is higher than the put's strike price. If the March copper futures contract is 76¢ per pound, a March 69¢ per-pound put is out-of-the-money. It gives the holder of the options contract the right to sell a futures contract at a price of 76¢, but since the market is trading at 69¢, it is unlikely the options contract would be exercised since it has no intrinsic value.

An option's premium will usually equal or exceed whatever intrinsic value the options contract has, if any. For example, if a crude oil options contract is in-the-money by $1 per barrel, its premium will almost always be at least $1.

Time Value

The time premium is the amount buyers are willing to pay for the options contract above its intrinsic value on the chance that, at some time prior to its expiration, it will move into the money. Out-of-the-money options all carry time premium since their intrinsic value is zero, as is that of at-the-money options.

The time premium for the in-the-money options contract is the amount that exceeds the option's intrinsic value and reflects the possibility that the options contract may move deeper into-the-money. The time value of an options contract shrinks as the expiration date approaches, with less and less time for a major change in market opinion, and a decreasing likelihood that the options contract will increase in value.

As prices fluctuate more widely and frequently, the premiums for options on futures increase, since the probability of the options contract attaining intrinsic value or moving deeper into the money increases. Accordingly, options writers demand higher premium payments. If market volatility declines, premiums correspondingly decline.

Volatility

Volatility measures the market's movement within a price range; the direction of the range is irrelevant.

Historical volatility indicates how much prices have changed in the past and is derived by using daily settlement prices for futures. Implied volatility, derived by using the option's premium, measures how much the market thinks prices will change in the future. As volatility increases, so does the value of options, all else remaining equal — for example, the premium for at-the-money $260 gold call options with 90 days to expiration will increase dramatically with incremental increases in volatility:

As prices fluctuate more widely and frequently, the premiums for options on futures increase, since the probability of the options contract attaining intrinsic value or moving deeper into the money increases. Accordingly, options writers demand higher premium payments. If market volatility declines, premiums correspondingly decline.

Out- of- the- money options

Out- of- the- money options are purchasing a strike price that is away from the current cash or futures price.

For example, if the December Gold Futures price is at $800 per troy ounce, the December $900 call is out- of- the- money. Therefore, this call option contract has no intrinsic value, only time value reflecting its premium price.

The time value of an option contract shrinks as the expiration date approaches, with less and less time before it expires. On expiration date, if the underlying future price does not exceed the strike, the options can expire worthless. For example, if the December Gold Futures price is at $900, a December 900 call option would be worthless. The futures price did not exceed the strike price on expiration date. Therefore, the option contract has no time value remaining. However, option contracts can be sold before expiration date to preserve the time value remaining or to make a profit.

The objective and strategy behind purchasing options that are out- of- the- money is to pay a low premium, in other words, believing that premium is undervalued based on market fundamentals and then anticipating that future prices will have a sharp increase. Therefore, the premiums for option contracts increases, since the probability of the option contract attaining intrinsic value increases. In some cases, out- of- the- money options could be profitable before current cash or futures price reaches the strike prices as a result of probabilities.

If future prices decrease, trade sideways or market volatility declines, call option premiums can decrease, reflecting the likelihood that the option contract will not go in the money. As the expiration date approaches, the call option premiums could be rising slowly or not rising at all when the futures prices are rising because the likelihood is that the option contract will not go in the money.

Buying Options "Going Long"

Options strategies based on long positions are most effective when sharp moves are expected, or unlimited margin risk cannot be tolerated by the trader. Hedging costs are limited to the premium, so the hedger retains his ability to participate in favorable price movements.

Selling Options "Going Short"

A trader or hedger can also profit from selling, or writing, options. Just as purchasing options is similar to buying insurance, selling options resembles the function of the insurance underwriter. The options writer collects the premium and is obligated to perform should the buyer exercise his option. If the buyer does not exercise his options contract, the seller retains the premium. Because the options writer's risk is potentially unlimited, short strategies that are not hedged are appropriate only for those willing and capable of assuming substantial risk. As long as the buyer has no incentive to exercise his options contract, the writer profits. For commercial users, selling options helps offset inventory carrying costs by generating premium income. By accepting the premium, the trader augments his current income and has downside protection equal to the premium. However, he gives up the ability to participate in favorable price moves, should they occur.

Futures or Options?

While futures offer price protection by allowing the holder of a futures contract to lock in a price level, a major appeal of options is that the holder of an options contract is afforded price protection, but still has the ability to participate in favorable market moves. Because the buyer of an options contract has the options contract but not the obligation to perform, he incurs no expenses beyond the initial premium. Therefore, if the market moves against a position, and a trader holds on to this option, the maximum cost is the price he has already paid for the option.

On the other hand, if the market moves in favor of a position, the virtually unlimited profit potential to the buyer of an options contract is parallel to a futures position, net of the premium paid for the options contract. Therefore, protection from unfavorable market moves is achieved at a known cost, without giving up the ability to participate in favorable market moves.

Futures Options
Risk Unlimited risk on long and short positions Defined and limited on purchase of puts and calls; unlimited on sale
Price Protection Establishes fixed price Establishes floor or ceiling price protection
Margin Required on long or short positions Futures style margins for sellers, margin contained in the cost of premium for buyers
Hedging Long, short, spread Multiple hedging strategies

For example, an oil refiner buying crude oil is exposed to the risk of rising crude prices, and benefits when raw material prices decline. The less costly the crude, the lower the manufacturing costs will be. In order to protect against crude oil cost increases, the refiner can either buy a crude oil futures contract or buy a crude oil call options contract.

Assume that the crude market is trading at $27 a barrel, but the refiner fears that prices may increase for his crude oil requirements in the next quarter. He could buy $27 calls for each of the three months involved for 70¢ a barrel, or $700 per contract (each contract is for 1,000 barrels), plus transaction costs.

If the price climbs to $30 per barrel, the refiner has earned $3,000 per contract ($3 per barrel on 1,000 barrels), less the $700 premium he paid for the call, for a net gain of $2,300. This gain would offset $2.30 of the $3-a-barrel increase in his cash crude costs.

What if crude oil prices fall? Because the holder of an options contract has a right and not an obligation, if price of crude oil falls to $25 per barrel, the refiner would let the options contract expire and buy his cash crude oil requirements at the lower, more favorable market price.

For comparison, assume that the refiner hedges his position only with futures. He buys crude oil futures at $27 and the market rises to $30. In that case, his profit on the futures position (excluding transaction costs) would be $3,000 or $3 per barrel, which would fully offset the increase in his cash crude costs. However, if the price falls to $25 per barrel, the refiner would have locked in his cost at $27 per barrel and forfeited the lower, more favorable market price.

The futures-only position gives him a stable oil acquisition cost – $27 – no matter which way prices move, at the cost of forfeiting the ability to participate in a decline in his raw material prices.

Likewise, a jewelry manufacturer who uses gold is exposed to the risk of rising metals prices, and benefits when gold prices decline. In order to protect against cost increases, the manufacturer can either buy a gold futures contract or buy a gold call options contract.

Assume that gold is trading at $265 an ounce, but the manufacturer fears that prices may increase for his requirements over the next six months. He could buy $265 call options for the six months for a premium of $4.00 an ounce, or $400 per contract (each contract is for 100 troy ounces), plus transaction costs.

If the price climbs to $285 per ounce, the jewelry company has earned $2,000 per contract ($20 per ounce on 100 ounces), less the $400 it paid for the call options contract, for a net gain of $1,600. This gain would offset $16.00 per ounce of the $20 increase in his cash costs.

Suppose gold prices then fall. Because the holder of an options contract has a right and not an obligation, if the price of gold falls to $250 per ounce, the jewelry company would let the options contract expire and purchase its cash gold requirements at the lower, more favorable market price.

Assume that the jewelry manufacturer hedges his position only with futures. He buys gold futures at $265 and the market rises to $285. In that case, his profit on the futures position (excluding transaction costs) would be $2,000 or $20 per ounce, which would fully offset the increase in his cash costs. However, if the price falls to $250 per ounce, the jewelry manufacturer would have locked in his cost at $265 per ounce, and forfeited the lower, more favorable market price.

The futures-only position gives him a stable gold acquisition cost – $265 – no matter which way prices move, at the cost of forfeiting the ability to participate in a decline in his raw material prices.

While the loss that can be incurred on an options contract is limited to the premium, the loss that can be incurred on a futures contract is the opportunity cost resulting from locking in a price and forfeiting the benefits of favorable market moves.

Although options and futures are by necessity closely related, they are not interchangeable. Each has advantages and disadvantages and can be used separately or in combination to achieve a variety of risk management and investment objectives.

Selecting A Strategy

There are many options strategies using various combinations of puts, calls, and futures that can be tailored to take advantage of a particular set of market expectations and circumstances. Ultimately, a trader's objectives, view of the market, and ability to carry risk will determine which strategy to use.

Options / Futures Strategies

Price Outlook Strategy Profit Risk
Bullish Buy Futures Unlimited Unlimited
Bullish Buy Call Unlimited Limited
Neutral / Bearish Sell Call Limited Unlimited
Bearish Sell Futures Unlimited Unlimited
Bearish Buy Put Unlimited Limited
Neutral / Bearish Sell Put Limited Unlimited
Increase In Volatility Buy Straddle Unlimited Limited
Decrease In Volatility Sell Straddle Limited Unlimited

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