How Options Work
Options come in two varieties: calls and puts. Calls are easier to understand because call buyers receive the right to buy things within a specified period of time. Take land, for example. You might have your eye on a particular house, but you're not sure it's the "right" property for you. So you talk the seller into letting you rent it for a year with an option (call) to buy it at a specific price at the end of that year. You pay a price for the option—one year's rent, and at the end of the year, you either have to exercise your option by buying the house at the pre-agreed price, or you forfeit the rent and don't buy the house.
In other words, a call gives the buyer the right to buy the underlying asset (in this example, a house) at a specific price within a certain period of time (in this example, one year). Of course, it is possible to purchase a call for just about any kind of asset—stocks, currencies, and futures contracts are a few that come to mind. The more easily an asset is traded, the more likely it is that an exchange will develop options for those assets (because that's how they make money—by providing a forum for trading the options). The most attractive feature of options is their limited risk--for buyers only. Buyers' risk is limited to the premium they pay. Thus, they know in advance how much they are risking: no more, no less.
In the futures industry, we are primarily interested in futures options; i.e., options with futures contracts as the underlying asset. Take gold, for example: you can buy a call on the COMEX (division of the NYM) that gives you the right to purchase a gold futures contract (one futures contract is for the delivery of 100 ozs. of gold at a certain time in the future) at a specified price, known as the strike price, within a certain period of time (before the call expires). Futures options have varying life spans, but you can buy one at any point during its life, meaning that it could have eight months remaining, two months remaining, or one day remaining before expiration. You also have a choice of strike prices. There are usually a handful of choices, depending on recent price volatility of the underlying asset. If you look over the premiums (prices) of the calls (with their various strike prices), you'll notice that they can vary considerably in price. And this is where the explanation of options gets complicated.
Option prices vary primarily because of two main factors: the relationship between the option's strike price and the underlying asset's price, and the likelihood that the underlying asset's price will change, relative to the strike price, in the time remaining before expiration.
If the strike price for your call is $650.00 per ounce and the underlying asset's price is $675.00, your call already has a $25.00 per ounce intrinsic value. In other words, you could theoretically buy the option, which gives you the right to purchase the gold futures contract at $650.00 per ounce when the price of the futures contract in the futures market is $675.00 per ounce. How much do you think you would have to pay for such a right? Probably at least $25.00 per ounce.
Now let's look at the second factor that affects option prices—the likelihood that the underlying asset's price will change relative to the strike price during the time remaining before expiration. It's fairly certain that prices will change, but what the call buyer really wants to know is, in which direction will it change? If the price goes up, he probably will make money. If the price goes down, he probably will make less money (or lose money). So he tries to predict the future price movement or trend. In fact, if the trend is upward, there is even a bias built into the call's price because it is more probable that prices will continue in that direction.
Going back to our gold futures contract call example, we would expect a call with a strike price of $650.00 to cost at least $25.00 when the underlying futures price is $675.00 per ounce, but its price could actually be somewhat higher, depending on the price trend for gold and the time remaining before expiration. It could be $30.00, $35.00, or more, depending on how likely the market thinks prices are to continue climbing. In a sense, the market is trying to guess where the underlying asset's price will be at expiration and go there now.
On the other hand, we must remember that options have a limited lifetime; i.e., they are wasting assets. They run out of time, and when they run out of time, all that's left is the amount by which they are in-the-money. In other words, the amount by which the underlying asset price is above the strike price of the call option. This is also known as the option's intrinsic value.
So, when we ask ourselves how likely it is for a call to go deeper into-the-money, and we remember that we only have a limited amount of time remaining before it expires, we see why it is that sudden movements in the underlying asset's price tend to catch the market by "surprise" and accentuate the results with higher or lower option prices. In short, sudden price movements in the underlying asset affect option prices by more than the movement of the underlying asset's price because of the expectations factor or component. This "expectations" component is also known as the time component or time value of the option. As you might expect, unless prices of the underlying asset are moving wildly as expiration approaches, the time premium or value tends to decrease fairly quickly. Watch out! If the option isn't in-the-money by the time the option expires, it becomes worthless. In fact, many options expire worthless. This is important when it comes time to figure out your strategy for using options.
If you are a hedger, you will probably buy an option and hold it until it expires. If you are speculating on a sudden price change, you'll probably buy the option. On the other hand, if you are speculating on a sideways market or gradually changing market, you might sell options (not recommended for most people, because you are subject to greater risk and margin calls!). Ask your broker which strategy he/she recommends for you.
Just a quick word about puts--puts give the buyer the right to sell the underlying asset at a specific price within a certain period of time. So if you are expecting prices to decline relatively quickly, or as a hedger, you are afraid prices might decline, you could buy a put for price protection or to speculate on declining prices.
For additional questions about options, please ask your broker.
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