Basic Options

Teacher: Jeff FichtelmanOPT 101

Approximate Length: 1 hour

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Table of Contents• Prerequisite Knowledge

• Basic Definitions

• Anatomy of an Option

• Basic Price Relationships

• Basic Option Strategies

• Recommended Courses

• Exam

OPT 101: Basic Options

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Prerequisite KnowledgePrerequisite knowledge:• Basic understanding of grain futuresPrerequisite course suggestions:• None

OPT 101: Basic OptionsTable of Contents

Prerequisite Knowledge

Basic Definitions

Anatomy of an Option

Basic Price Relationships

Basic Option Strategies

Recommended Courses

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Basic Definitions• Grain Futures Acronyms• Option Contract• Long• Short• Call Option• Put Option• Options on Futures• “Moneyness”• Options Overview

Basic Definitions

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Grain Futures AcronymsBasic Definitions

• Grain Futures– “C” = Corn– “S” = Soybeans– “W” = Wheat– “O” = Oats

• Futures Months– “F” = January– “G” = February– “H” = March– “J” = April– “K” = May– “M” = June– “N” = July

• Futures Months (cont.)– “Q” = August– “U” = September– “V” = October– “X” = November– “Z” = December

• Years– “11” = 2011– “12” = 2012

• Examples– CZ11 = Dec 2011 Corn– SX12 = Nov 2012 Soybeans– WN13 = July 2013 Wheat

Basic Definitions

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Option ContractBasic Definitions

• Definition– Two Parties

• Buyer of Option• Seller of Option

– Buyer has Right to Exercise Contract– Seller is Obligated if Buyer Exercises Contract– Buyer pays Seller premium for taking on risk

• Example 1 – Option on a House• Example 2 – Car Insurance

Basic Definitions

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LongBasic Definitions

• Definition– Makes money in a rising market– Also known as “Buyer” or “to buy”– Farmers are typically long their cash crop

Buy Price Where buyer goes “long”

Table of Contents

Basic Definitions

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ShortBasic Definitions

• Definition– Makes money in a falling market– Also known as “Seller” or “to sell”– Farmers typically sell (go short) futures to offset their long

cash crop

Sale Price Where seller goes “short”

Table of Contents

Basic Definitions

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Call OptionBasic Definitions

• Definition– Buyer of Call:

• Right to go Long the underlying futures at the strike price• Pays seller defined premium

– Seller of Call:• Obligated to go Short the underlying futures at the strike price• Receives a defined premium

• Example – CZ11 4.50 Call @ 25c– Buyer of Call has right to go long CZ11 @ 4.50– Seller of Call is required to go short CZ11 @ 4.50– Buyer of Call pays Seller of Call 25c for Right to go Long

Basic Definitions

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Put OptionBasic Definitions

• Definition– Buyer of Put:

• Has Right to go Short the underlying futures at the strike price• Pays seller defined premium for this Right

– Seller of Put:• Is Obligated to go Long the underlying futures at the strike price• Receives a defined premium from the buyer to take on this obligation

• Example – CZ11 4.00 Put @ 15c– Buyer of Put has right to go short CZ11 @ 4.00– Seller of Put is required to go long CZ11 @ 4.00– Buyer of Put pays Seller of Put 15c for Right to go Short

Basic Definitions

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Options on FuturesBasic Definitions

• Definition– One Option Contract = One Futures Contract– Options specify which futures contract the seller will need to

provide to the buyer

• Examples– CZ11 4.50 Call

• December 2011 Corn Futures

– CK11 5.00 Put• May 2011 Corn Futures

– SN11 13.00 Call• July 2011 Soybean Futures

Basic Definitions

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“Moneyness”Basic Definitions

• In-the-money– Calls = If Strike < Futures (Buy Low)– Puts = If Strike > Futures (Sell High)

• At-the-money– Calls / Puts = If Strike = Futures

• Out-of-the-money– Calls = If Strike > Futures (Buy High)– Puts = If Strike < Futures (Sell Low)

Basic Definitions

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Right Right

Obligation ObligationObligation

Option Overview – Part 1Basic Definitions

Call Put

Option Contract

SellOpt

The Right or The Obligation

Right Right

Obligation

Table of Contents

Basic Definitions

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Option Overview – Part 2Basic Definitions

Call Put

Option Contract

SellOpt

deLong Short

Short Long

Long Short

Short Long

Long or Short Underlying Futures?

Table of Contents

Basic Definitions

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Anatomy of an Option• How it’s written• Number of Contracts• Underlying Commodity • Strike Price• Call or Put• Option Premium

– Time Premium– Intrinsic Value

• Expiration Date• American Options

– vs. European Options

Basic Definitions

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How it’s WrittenAnatomy of an Option

• +20 CZ11 4.50 Call @ 25c• +100 SX12 14.00 Calls @ 55c• -5 WN11 6.00 Put @ 30c• -15 CH12 5.00 Call @ 30c

Basic Definitions

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Number of ContractsAnatomy of an Option

• +20 CZ11 4.50 Call @ 25c• Definition

– Number of option contracts to be bought (+) or sold (-)– Equals number of underlying futures– Can not be written down by # of bushels

• i.e. +10,000 bu. CZ11 4.50 Call @ 25c (WRONG)• Note: 1 contract = 5,000 bushels (grain options on futures – C, S, W, O)

– Options can not be traded in “odd lots”• Odd Lots = increments not divisible by 5,000 (i.e. 7,500)

• Example above – Buying (“going long”) 20 contracts, or 100,000 bushels

Basic Definitions

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Underlying CommodityAnatomy of an Option

– Defines which futures contract will be assigned to the buyer of an option

– Refer to the “Grain Futures Acronyms” slide

• Example above – December (“Dec”) 2011 Corn

Basic Definitions

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Strike PriceAnatomy of an Option

– Defines the price at which the futures are transacted

• Example above – The buyer of this call has the right to go long December 2011

corn at $4.50– The seller of the call is obligated to go short December 2011

corn at $4.50 if the buyer exercises his/her right

Basic Definitions

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Call or PutAnatomy of an Option

– Defines whether the option is a call or a put

• Example above – Call Option (i.e. “Call”)

Basic Definitions

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Option PremiumAnatomy of an Option

– What the buyer of an option pays the seller• Grain Options = price per bushel (1 contract = 5,000 bushels)

– Determined by a market• Highest bid (i.e. buyer) vs. Lowest offer (i.e. seller)

– Can be calculated from a formula• Black-Scholes Option Pricing Formula (Theoretical price)• Put-Call Parity (Arbitrage price)

• Example above – 25 cents per bushel ($1,250 per contract = $0.25 x 5,000 bu.)

Basic Definitions

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Option Premium – Intrinsic ValueAnatomy of an Option

• Definition– Calls = Max (Futures – Strike, zero)– Puts = Max (Strike – Futures, zero)

• Example 1– CZ11 4.50 Call @ $0.50– CZ11 Futures @ $4.70– Intrinsic Value = Max ($4.70-$4.50, zero) = $0.20

• Example 2– CZ11 4.50 Put @ $0.30– CZ11 Futures @ $4.70– Intrinsic Value = Max ($4.50-$4.70, zero) = $0.00

Basic Definitions

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Option Premium – Time PremiumAnatomy of an Option

• Definition– Calls or Puts = Option Premium – Intrinsic Value

• Example 1– CZ11 4.50 Call @ $0.50– CZ11 Futures @ $4.70– Time Premium = $0.50 - $0.20 = $0.30

• Example 2– CZ11 4.50 Put @ $0.30– CZ11 Futures @ $4.70– Time Premium = $0.30 - $0.00 = $0.30

Basic Definitions

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Expiration DateAnatomy of an Option

– Standard Options expire:• The last Friday preceding the first notice day of the corresponding

futures contract month by at least two business days.

• Example above – Corresponding Futures Contract Month: December 2011– First Notice Day: December 1, 2011– Option Expiration: November 25, 2011

Basic Definitions

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American OptionsAnatomy of an Option

– American Options can be exercised by the buyer at any time from purchase until expiration of the option contract• All standard grain options traded on the CME/CBOT are American

Options

– European Options can only be exercised by the buyer of an option contract on the expiration date

• Example above – American Option– Buyer can exercise right to go long CZ11 @ $4.50 anytime

between purchase of option contract and close of trading on November 25, 2011

Basic Definitions

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Basic Price Relationships• In a rising market• In a falling market• In a sideways market

Basic Definitions

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In a Rising MarketBasic Price Relationships

• Starting Prices– CZ11 5.00 Call @ 60c– CZ11 5.00 Put @ 60c– Starting CZ11 Futures = $5.00– Current Date = 12/24/2010– Option expiration date = November 25, 2011

• Scenarios1. CZ11 @ $5.50 (up $0.50); in 100 days (date: 4/23/2011)

• CZ11 5.00 Call = $0.81 (up $0.21)• CZ11 5.00 Put = $0.31 (down $0.29)

2. CZ11 @ $6.00 (up $1.00); in 100 days• CZ11 5.00 Call = $1.19 (up $0.59)• CZ11 5.00 Put = $0.19 (down $0.41)

Basic Definitions

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In a Falling MarketBasic Price Relationships

• Scenarios1. CZ11 @ $4.50 (down $0.50); in 100 days (date: 4/23/2011)

• CZ11 5.00 Call = $0.27 (down $0.33)• CZ11 5.00 Put = $0.77 (up $0.17)

2. CZ11 @ $4.00 (down $1.00); in 100 days• CZ11 5.00 Call = $0.12 (down $0.48)• CZ11 5.00 Put = $1.11 (up $0.52)

Basic Definitions

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In a Sideways MarketBasic Price Relationships

• Scenarios1. CZ11 @ $5.00; in 100 days (date: 4/23/2011)

• CZ11 5.00 Call = $0.50 (down $0.10)• CZ11 5.00 Put = $0.50 (down $0.10)

2. CZ11 @ $5.00; in 200 days (date: 7/12/2011)• CZ11 5.00 Call = $0.38 (down $0.22)• CZ11 5.00 Put = $0.38 (down $0.22)

Basic Definitions

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Basic Option Strategies• The P/L Chart• Long Call Option• Long Put Option

Basic Definitions

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The Profit & Loss (P/L) ChartBasic Option Strategies

Basic Definitions

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Long Call OptionBasic Option Strategies

Long CZ11 5.00 Call @ 65c (CZ11 = 5.00)Scenario = 167 days from now (halfway until expiration)

Long @ 5.00

Long Futures Long CZ11 5.00 Call @ 65c

Market Price = 5.00

Break-even @ 5.65

Max loss = 65cMax loss = 5.00

Max gain = ∞Max gain = ∞

Table of Contents

Basic Definitions

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Long Call OptionBasic Option Strategies

Long CZ11 5.00 Call @ 65c (CZ11 = 5.00)Scenario = 167 days from now (halfway until expiration)

Table of Contents

Basic Definitions

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Long Call Option (different strikes)Basic Option Strategies

Long CZ11 5.00 Call @ 65c (Strategy 1)Long CZ11 6.00 Call @ 40c (Strategy 2)

Table of Contents

Basic Definitions

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Long Put OptionBasic Option Strategies

Long CZ11 5.00 Put @ 65c (CZ11 = 5.00)Scenario = 167 days from now (halfway until expiration)

Short @ 5.00

Short Futures Long CZ11 5.00 Put @ 65c

Market price = 5.00

Break-even @ 4.35

Max gain= 4.35

Max gain = 5.00

Max loss = ∞ Max loss = 65c

Table of Contents

Basic Definitions

Recommended Courses

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Long Put OptionBasic Option Strategies

Long CZ11 5.00 Put @ 65c (CZ11 = 5.00)Scenario = 167 days from now (halfway until expiration)

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Table of Contents

Basic Definitions

Recommended Courses

Recommended CoursesPrerequisite Course Suggestions:• NoneRecommended Next Courses:• OPT 201: Intermediate Options• OPT 301: Advanced OptionsOther Complementary Courses:• EXL All: Learning the Excel Models• FRM All: Any Farmer Specific Courses• SPC All: Any Grain Speculator Courses• TCA All: Any Technical Analysis of Grain Market

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Basic Definitions

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