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Q: I’m confused by options terminology and pricing. Do I buy the bid, ask or last price? How do I know if my option is in-the-money?
A: Lind Plus Senior Market Strategist Matt Krupski answers.
It’s easy to get confused by all of the different terminology you may hear when talking about options on futures. Let’s start with a basic definition of an option.
An option is a contract (an agreement between two parties) in which one party (the buyer of the option) has the right, but not the obligation, to take a specified position in a particular futures market. This market is referred to as the “underlying.” The specified position can be a long position (call option) in the underlying or a short position (put option) in the underlying.
For example, buying a call on gold futures gives the option buyer the right to be long a gold futures contract. Buying a put on the Dollar Index gives the option buyer the right to be short a Dollar Index futures contract. The terms of the contract are standardized by the exchanges, so they are transferable among other parties. So, you can buy a call from one person and sell it to another and have a flat position. Let’s look at some specific options terms and concepts.
Strike Price
This is the price the option buyer would be long a futures contract from (in the case of a buyer of calls) or short from (in the case of an buyer of puts). Options are available at a wide variety of strike prices. The owner of a $1,000 gold call has the right to be long a gold futures contract from $1,000 an ounce. The owner of a 75 Dollar Index put has the right to be short a Dollar Index futures contract from 75. It is important to note that the owner of a $1,000 gold call has the right, but is not obligated to buy, a gold futures contract at $1,000. He would only exercise this right if gold is $1,000 or higher. If gold were to go to zero, his only risk would be what he paid for his option. Similarly, if the Dollar Index futures go to 100, the owner of the 75 put would not want to exercise his right to sell the dollar index futures contract at 75.
In-the-Money, Out-of the Money, At-the Money
You will often hear the terms in-the-money, at-the-money, and out-of-the money mentioned. This is in reference to the relationship between where the futures contract is currently trading and the strike price of an option. If the price of the underlying futures contract and the strike price are the same, then the option is referred to as at-the-money. If the strike price of a call (put) is higher than (lower than) the price of the underlying, the option is said to be out-of the money. If the strike price of a call (put) is lower than (higher than) the underlying, then the option is said to be in-the-money. So, if gold futures are trading at $950, the $900 call is in-the-money, the $950 call is at-the-money, and the $1,000 call is out-of the money. If the Dollar Index futures contract is trading at 80, the 75 puts are out-of the money, the 80 puts are at-the-money, and the 85 puts are in-the-money.
Expiration/Month: European Style and American Style
Options have a defined date associated with them, referred to as the expiration. This is the day the contract between the parties expires. Contract expirations are standardized in each market by the exchanges. Options are usually listed monthly. Sometimes you will also hear someone refer to European-style or American-style options. European-style options can only be exercised at the expiration of the contract. American-style options can be exercised at any point between now and expiration.
Premium
The right to be long (or short) a futures contract at a specified time and price has value, and premium represents this value as the cost of the option to the investor. When you buy a call or put, you pay the premium and the seller collects the premium. The premium (value) of the option is a function of the probability of the option being “right.” If there is more time until expiration, there is a greater value to owning the option because there is more time for the option to be in-the-money at expiration. In early June, an August Dollar Index 75 put will be worth more than a July Dollar Index 75 put because there is one more month of time in which the dollar index can decline to below 75. Similarly, with gold futures trading near $970, the right to be long gold from $1,000 at December expiration (the December gold $1,000 call) would have a greater value than the right to be long gold from $1,200 (the December gold $1,200 call) because the chances of gold being above $1,000 are greater than being above $1,200.
Intrinsic Value and Time Value
Intrinsic value is the value that could be realized by exercising the option today. Only in-the-money options have intrinsic value. A December gold $900 call has an intrinsic value of $50 if gold is currently trading at $950. You could immediately realize $50 by exercising your right to be long a futures contract from $900 and then immediately sell it back out at the market price of $950.
As long as time remains on the option, there is a chance for the option to increase in value; an underlying futures market goes up for calls, or the underlying goes down for puts. That’s called time value. All options have time value, including in-the-money options. As each day passes, the option will lose a little bit in time value because there is less time to “be right.” The total value of an option (its premium) is the sum of its time value and its intrinsic value. Since at-the money and out-of the money options have zero intrinsic value, their premium is all time value.
Volatility
You often hear about the relationship between volatility and options. If people perceive that the futures market will be increasingly volatile (large swings in price), then options should increase in value because if large price swings occur, than the chance of an option finishing in-the-money increases. In addition, volatile markets can discourage people from trading the futures market due to the resulting large swings in account value, and encourage them to buy options on the futures instead. That increases the demand for options. Remember, an outright futures position carries potentially unlimited risk, while the option buyer’s risk is defined (what he or she pays for an option). Increasing demand for options also increases their price.
Bid/Ask, Settlement Value, and Last Price
Due to the large number of options available (numerous strikes over numerous months in both calls and puts), price discovery is more difficult in options than in futures. The last prices displayed by exchanges may be old or “stale,” because market conditions may have changed from the time the option traded at that price and the present moment. Market makers exist in options markets to provide liquidity and will quote a price at which they will buy or sell any option listed by the exchange.
The best available price at which someone will buy a specified option is referred to as the “bid.” The best available price at which someone will sell a specified option is the “ask,” also called the “offer,” for that option. As the underlying market moves around, the bid/ask will change. However, the price of the option is only updated when an option trades. Often, the current bid/ask of an option is quite different from the last price displayed. The difference between the bid and the ask is referred to as the “spread.” Every day, at the close of the markets, the exchanges update the value of the option, usually using the midpoint of the bid/ask spread to value the option. This is the settlement value.
Delta, Gamma, Theta, Vega, Rho
Also referred to the option “Greeks,” these are factors that measure the sensitivity of an option’s price to various factors (the underlying, time, volatility, interest rates). They are too complex to go into here; you can read another article I wrote called “The Greeks” on my bio page for more information on that topic.
Feel free to contact me with any questions you might have about options or futures trading, and how to incorporate some of these concepts into specific trading strategies in the markets today.
Matt Krupski is a Senior Market Strategist with Lind Plus. He can be reached at 877-847-3034 or via email at mkrupski@lind-waldock.com.
Kristina Zurla Landgraf is editor of Lind eWire. She can be reached at editor@lind-waldock.com.
Futures trading involves substantial risk of loss and is not suitable for all investors.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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