How Do Commodity Options Work?
by: Michael Smith
How is the value of an option figured out?
First you have to understand the meaning of intrinsic and extrinsic. The option premium is made up of both of these values. Intrinsic is the value of the option if you exercised it to the futures contract and then offset it. For example if you have a Nov. $5 soybean call and the futures price for that contract is $5.20 hence there is a .20 intrinsic value for that option. Soybeans are a 5000 bushel contract so 20 cents multiplied by 5000= $1000 intrinsic value for that option.
Now let's say that same $5 Nov. soybean call costs $1600 in premium. $1000 of the cost is intrinsic value and the other $600 is extrinsic. Extrinsic value is made up of time value, volatility premium and demand for that specific option. If the option has 60 days left until expiration it has more time value than it would with 45 days left. If the market has large price movements from low to high the volatility premium will be higher than a small price movement market. If many people are buying that exact strike price, that demand can artificially push up the premium as well.
How much will an option premium move in relation to the underlying futures contract?
You can figure this out by finding out the delta factor of your option. The delta factor tells you how much the change in premium will occur in your option based on the underlying future contract's movement. Let's say that you think Dec. gold will go up by $50/ounce or $5000/contract by expiration. You bought an option with a .20 or 20% delta factor. This option should gain approximately $1000 in premium value of the $5000 expected gold futures price movement.
Can an option speculator have a profit before the option has intrinsic value?
Yes, as long as the option premium increases enough to cover your transaction costs such as commission and fees. For example, you have a $3 Dec. corn call and Dec. corn is at $270/bushel and your transaction costs were $50. Let's say your option has a 20% delta and the Dec. corn future market moves up 10 cents/bushel to $2.80/bushel. Corn is a 5000 bushel contact so 1 cent multiplied by 5000= $50. Your option premium will increase by approximately 2 cents = $100. Your break even was $50 so you have a $50 profit without any intrinsic value because you are still out of the money by 20 cents.
Past performance is not indicative of future results and only risk capital should be used in commodity investing. There are no guaranteed good trades. Futures and options investing is risky and capital loss can occur. Cash, options, and futures do not necessarily react to certain stimuli in the same manner.
About The Author:
Michael Smith is a 12 year veteran of the commodity option investing markets. Visit www.tkfutures.com to learn more about futures and options investments.
August 2006
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