I'm a paragraph. Click here to add your own text and edit me. It’s easy. Just click “Edit Text” or double click me to add your own content and make changes to the font. Feel free to drag and drop me anywhere you like on your page. I’m a great place for you to tell a story and let your users know a little more about you.
Introduction to Options
What is an option?
An option on a futures contract is the right, but not the obligation, to buy or sell the underlying futures contract at a predetermined price on or before a given date in the future.
Here’s a simple example:
Suppose your company is considering moving to a new city, and you may need to move. You could buy a house in the new city, just in case, but that may not be the best use of your capital. And if the company decides not to move, then you have a house you don’t need.
But, what if you could buy an option on a house in the New City?
You will need to pay the owner of the house for this “right”, and the cost of that right is called the option premium.
If the company moves, you would exercise your option to purchase the house at the predetermined price. If the company does not move, then you would simply not exercise your right or option to buy the house. When this happens, the owner of the house will still keep the option premium.
Options on futures work fundamentally the same way, but with more standardized terms, and options permit you to lock in price but with an added layer of flexibility. For example, when you buy an option on a future, you pay an upfront premium, and agree to buy that particular futures contract at a specific price.
You have the right but not the obligation to exercise your option at that price and receive the futures contract. So if prices move against you, you have the option of not exercising the contract.
Every option transaction must have a buyer and a seller.
Buyers pay the premium to the seller, and sellers hold the risk of price movement.
Options can be used like insurance policies to limit losses on a futures contract.
They can also be used for speculative purposes, whether you are selling options to receive premium income or using options to establish a position in a particular commodity, index or interest rate.
As hedging instruments, options can produce offsetting gains in the face of adverse price changes in the cash market.
Options permit you to efficiently deploy capital, in the form of option premium. In this case, you can participate in the price movements of the underlying asset, without having to buy the asset outright.
So when it comes to options on futures, both buyers and sellers have an array of choices to efficiently deploy their capital, while expressing their opinion or managing their price risk in the marketplace.
Understanding Option Contract Details
Contract details refer to the terms of an option contract. How an option contract gains or loses value, and therefore creates a benefit to you as the holder of the option, is dependent on key option contract details. Understanding the key contract details is essential to determining how and when an option will meet your financial objectives. Choosing the right options contract for you is dependent on your objectives. For example, if you want to protect or hedge an asset, you will need to know the contract details to determine the best fit for your portfolio; when speculating, your trading strategy might be influenced by the contract details.
Key Option Elements
The deliverable for every CME Group option is a futures contract. This is called the “underlying instrument” or the “underlier”. Futures contracts also have an underlying product such as an interest rate, equity index, a foreign currency rate, or some other commodity.
Each option also has its own expiration or maturity date. This is the last day on which an option can be exercised into the underlying futures contract. After the expiration or maturity date, the option contract will cease to exist; the buyer cannot exercise and the seller has no obligation.
This is the agreed price at which a transaction will happen, if the option is worth exercising. The strike price for the option contract will determine the value at expiration.
Option contracts fall into two categories, call options and put options.
A call option is the right to “buy” the underlying product at a predetermined price.
A put option is the right to “sell” the underlying product at a predetermined price.
Before establishing your option position, you will need to carefully consider your financial strategy and objectives. Whether you are hedging or pursuing a trading strategy, close alignment of the contract details are important to achieving desired results from your option position.
Get to Know Underlying (Options on Futures)
Get to Know Underlying (Options on Futures)
Option contracts are written on a broad cross section of underlying futures contracts. Since 1982, when option contracts on futures were first introduced, the options market has grown significantly and now most major US futures contracts have companion option contracts. Very few new futures contracts are listed on major exchanges without an associated option contract. Hedgers and speculators alike spend a great deal of time examining price behavior unique to each underlying futures contract. Historic price data along with other statistics, such as open interest, volatility, delta, etc., are useful in choosing the strike price and time frame for an option contract.
CME Group is the world’s largest Derivatives Exchange. In 2016, average daily volume reached a record 15.6 million contracts and open interest exceeded a record 120 million contracts.
Both futures and options on futures are called derivatives because they “derive” their value from something other than themselves. For example, a corn futures contract derives its value from the actual underlying corn that can be delivered into the contract.
An option on a future is no different in this regard, but the underlier is another derivative, namely the corn future, which in turn has actual corn as its underlier.
Option contracts span a variety of asset classes, including Interest Rates, Equity Indexes, Foreign Exchange, and physical commodities.
Each option you hold is either the right to buy (call option) or the right to sell (put option) an underlying futures contract as defined by the name of the underlying commodity, index, or interest rate future on which the option is based.
If you are holding a Gold option on a commodity future, you will have the opportunity to either buy, in the case of a call, or sell, in the case of a put, a Gold futures contract at a specific price on or before the expiration of that contract.
If you are holding an S&P 500® Equity Index option, then you have the opportunity to either buy or sell a future, at a specified price, on the S&P 500®-index level for a defined period of time.
When holding a Treasury option, you have the right to buy or sell a $100,000 US Treasury bond futures contract at a specific price during a certain period of time.
In each case, the underlying contract influences the value of the option: the strike range, the premium, and the timing for each option.
Doing your homework on the underlying futures contract, may help you identify opportunities in the associated options contracts.
What is Exercise Price (Strike)?
One key characteristic of an option contract is the agreed upon price, known as the strike price or exercise price.
The strike price is the predetermined price at which you buy (in the case of a call) or you sell (in the case of a put) an underlying futures contract when the option is exercised.
Strike Price Ranges
When trading options you can choose from a range of strike prices that are set at predefined intervals by the exchange. The interval range may vary depending on the underlying futures contract.
While futures can trade at prices in between these intervals, the exchange attempts to set the option strike intervals to meet the market’s need for liquidity and granularity.
Each option product will have a unique price interval rule that is based on the product structure and the needs of the market. Not only will products have varying intervals, but also within certain products, the intervals will change depending on the expiration month.
For example, options on corn futures have an interval of 5 cents for the two front months, of the expiring futures contract and then transition to 10 cent intervals for contracts 3 months and beyond.
The full range of strike prices, for many options products, will be determined by the previous day’s daily settlement price for the futures contract.
Over time the entire range may expand beyond the initial listed boundaries, due to large market movements. In addition, strike intervals can become more granular as options move closer to expiration.
Example Strike Price Range
In our example we are going to look at a fictional contract with a December expiration. At outset of the option contract, the price rule dictates a 10 point interval and a 40 point range. Assume the underlying futures contract is trading around 100 points, the option price range will be set at 80, 90, 100, 110, and 120.
As the price of the underlying futures contract moves, the exchange will monitor and adjust the range of strike prices.
After the first quarter the futures market fell to 83 points, therefore another strike price at 70 was made available.
In the third quarter the futures contract rallied higher. The option contracts are now much closer to expiration and have increasing trading activity. To meet demand, additional strike prices at one point intervals are made available between 80 and 100.
By the last quarter the market continued upward and additional one point intervals were needed between 100 and 110.
What is Expiration Date (Expiry)?
Options do not last forever. They expire or terminate; they all have an ending date.
Options are tied to an underlying futures product and all futures products have a settlement date. If the futures contract no longer exists, then clearly an option on that contract can no longer exist either.
When do options expire?
When it comes to options on futures, there may be a variety of option expiration dates you could trade for the same futures contract.
You may find some option expirations align with the expiration of the underlying futures contract. In other cases a futures product could have a variety of shorter term options listed. These shorter term options offer traders greater precision and flexibility to expand their trading strategies.
Assume the E-mini S&P 500® futures contract (ES) has a settlement date in June.
Quarterly options contracts are offered on the E-mini S&P 500® futures contract. In this case the June quarterly option contract would expire at the same time as the futures contract.
Monthly contracts are also offered for the same futures product. With a monthly option contract you can express a short term opinion on this longer dated futures contract.
For each listed month, such as May and April, you can trade an option that will expire within a month and settles into the same June ES futures contract.
If your time horizon is even shorter, there are weekly options on the E-mini S&P 500 futures contract.
A rolling list of five weekly options that expire each Friday is offered on most products. After each weekly front-end contract expires, another back-end weekly is listed.
Physically Delivered Commodity Options
When it comes to physically-delivered commodities, option expirations will expire prior to the futures settlement. This happens so that traders have an opportunity to mitigate delivery of the physical product.
For example, when WTI Crude Oil futures settle in June, the WTI option will have a May expiration date. If the option is exercised into the active futures contract, the trader has time to adjust their futures position to either offset the position or make plans to take delivery.
Options can have a variety of option expiration dates, giving you the flexibility to find a product that meets your trading needs.
Explaining Call Options (Short and Long)
What is a Call Option?
A call option is the right to buy the underlying futures contract at a certain price.
When traders buy a futures contract they profit when the market moves higher. The call option has a similar profit potential to a long futures contract. When prices move upward the call owner can exercise the option to buy the future at the original strike price. This is why the call will have the same profit potential as the underlying futures contract.
However, when prices move down you are not obligated to buy the future at the strike price, which is now higher than the futures price because that would create an immediate loss.
With this downside protection why would any trader buy a futures contract instead of call?
The potential to profit on a call option does not come without a cost. The seller or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a call option pays a premium to the seller of a call option.
As a result of the added cost of the premium, the profit potential for a call is less than the profit potential of a futures contract by the amount of premium paid. The price of the future must rise enough to cover the original premium for the trade to be profitable. Moreover, options premiums are impacted by time decay and changes in volatility (futures are not).
The breakeven point for a call is the strike price plus the premium paid. So if you paid 4.50 points for a 100 call option, the breakeven is 104.50. The most you could lose is the premium or 4.50 points.
For every long call option buyer, there is a corresponding call option “writer” or seller. If you sell the call option, then you receive the premium in return for the accepting the risk, that you may need to deliver a futures contract, at a price lower than the current market price for that future.
Option sellers have unlimited risk if the futures price continues to rise.
Call sellers will profit as long as the futures price does not increase beyond the value of the premium received from the buyer.
The breakeven point is exactly the same for the call seller as it is for the call buyer.
Call Buyers have protection in that their risk is limited to the premium they must pay for the call option. The maximum risk of a call option is the premium paid. They can lock in the strike price and profit (should the underlying rise far enough) while risking only the upfront premium paid.
Explaining Put Options (Short and Long)
A put option is the right to sell the underlying futures contract at a certain price.
When traders sell a futures contract they profit when the market moves lower. A put option has a similar profit potential to a short future. When prices move downward the put owner can exercise the option to sell the futures contract at the original strike price. This is when the put will have the same profit potential as the underlying futures.
However, when prices move up you are not obligated to sell the future at the strike price, which is now lower than the futures price because that would create an immediate loss.
Why would any trader short a future instead of buying a put?
The potential to profit on a put option does not come without a cost. The “seller” or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a put option pays a premium to the seller of a put option.
As a result of the added cost of the premium, the profit potential for a put is less than the profit potential of a futures contract by the amount of premium paid. The price of the futures contract must fall enough to cover the original premium for the trade to be profitable.
The breakeven point for a put is where the profit on the futures contract that you can purchase at the strike price is equal to the premium paid for the call.
For every long put option buyer, there is a corresponding put option “writer” or seller. If you have written the put option, then you receive the premium in return for the accepting the risk that you may need to buy a futures contract at a higher price than the current market price for that future.
While Put option sellers don’t have unlimited risk, the risk of writing puts can still be very large. The most a put option seller can lose is the full strike price minus the premium received. If you sell a 100 put option, and the underlying future drops to 20. You will have an 80pt loss minus the premium you took in which will only offset a small portion of the loss. In reality, most futures contracts don’t lose 80 percent of their value as in the example above, but losses on ANY short option can be substantial…so do your homework and fully understand the risks.
Put sellers will profit as long as the futures price does not fall beyond the value of the premium received subtracted from the strike price. For example, if you sell a 100 put strike and receive a premium of 6.00 pts. You will profit as long as the future is above 94 (strike minus the put premium).
The breakeven point is exactly the same for the put seller as it is for the put buyer.
Put options are the right to sell the underlying futures contract. Buyers of the put have some protection against adverse price movements in that they have limited risk (only the premium paid is at risk). On the other hand, hedgers can also use puts to protect against a declining price. Sellers of put options collect premium and accept the risk they may have the underlying “put” into their account resulting in a long futures position, a position that might be at a price much higher than is currently trading in the market.
Using our put selling example, if you sold the 100 put and the price of the underlying declined to 80 at expiration. If the buyer exercised his option, you would be assigned and have the futures put to you at 100 despite the fact it was trading fully 20 points lower in the market. While buyers have limited risk when buying puts and calls, the seller has substantial and virtually unlimited risk.
Understanding AM/PM Expirations
Option Expiration: A.M. or P.M.
Every option contract has a specific expiration date, and time. The time of expiration can be either in the morning (a.m.) or in the afternoon (p.m.).
Options that expire at the close of the market are considered p.m. and options that expire the morning of the last trading day are a.m.
The vast majority of options on futures expire at the close of the market on the last trading day, but there are notable exceptions. Options with a.m. expiration are generally written on a future contract that has the same expiration date and time. Futures that are financially settled, meaning they settle to cash payments rather than physical commodities, are often settled using a.m. expiration.
In the case of the S&P500 futures contracts, the final settlement price is determined by the opening prices of all the individual companies that make up the index. This settlement calculation is performed by the index administrator. For the S&P500 indices, the administrator is the Standard and Poor’s Company and they will provide a Special Opening Quote (SOQ), to indicate the final settlement price.
Options on those futures use the SOQ as a fixing price, to determine whether the option will be exercised, by comparing the SOQ to the strike price. For example, if a call option has a strike that is below the SOQ, it will be exercised. By exercising the option, the future will now be purchased at the strike price and on the same day be settled at the more advantageous SOQ price.
Options with a p.m. expiration are calculated using the value of the underlying future at the close of market on the last trading day for the option.
Although most options expire at the end of a trading day, it is important for traders to understand not only the date, but the specific time when their option may expire.
Learn About Exercise and Assignment
Exercise and Assignment
Options buyers exercise their options.
Options sellers are assigned when an option is exercised.
Exercising your right
A call option is the right to buy the underlying future at the strike price. The process for activating that “right”, is called “exercising the right” or simply to “exercise” the option. For a call option, that activity is also referred to as “calling the underlying” away from the option seller.
Options buyers (either put or call buyers) are the only ones that control whether an option can be exercised. Option sellers have the obligation if assigned and thus have no control over the exercise procedure.
A put option gives the owner of the option, the right to “put” the underlying future, to the seller of the option. Imagine if a store offers a “30 day no questions asked return policy”, that is like a “put”. You can “put” the item back on the store’s shelf and get a refund. If you return the item to the store, you have “exercised your right” to sell the item back to the store.
Option buyers are the only options traders who can “exercise” the right. Call owners, those who are “long the call”, can exercise their right to buy the underlying at the strike price. And put owners, those who are “long the put”, can exercise their right to sell the underlying at the strike price.
Sellers of call options are obligated to sell you that future, at a specific price. They were paid a premium to take on the risk of having to sell you something at a lower price than the current market.
Similarly, the writers of put options are obligated to buy that future at the specific price, that is higher than the current market price.
When an option owner exercises the right embedded in the contract, someone has to be assigned the duty of fulfilling the obligation, and it may not be the original person who sold the option.
The process of assigning options is performed by the central clearing house. CME Clearing using an algorithm to randomize the assignment to the options sellers.
Options owners exercise their contracts when markets move in their favor. Sellers of options accept premium and could be assigned when markets benefit the buyers.
Long call option upon exercise results in long futures
Short call option upon assignment results in short futures position (futures called away)
Long put option upon exercise results in short futures position
Short put option upon assignment results in long futures position (long futures put into their account)
Understanding the Difference: European vs. American Style Options
American Versus European Style Options
European and American style options are not regional options. They are actually terms used to describe two different types of option exercise.
European Style Options: can be exercised only at expiration.
American Style Options: can be exercised at any time prior to expiration.
The majority of CME Group options on futures are European style and can be exercised only at expiration. Some of the notable exceptions that have American style expiration are the quarterly options on the S&P500 futures contracts, Eurodollar options, and Treasury options.
Even though most CME Group options are European-style and can be exercised only at expiration, it is important for traders to understand style of option they are interested in trading.
Calculating Options Moneyness & Intrinsic Value
Value of an Option
When traders talk about the value of an option contract, they tend to use a common set of terms to describe the varying levels of an option contract. The terms they use are time until expiration, time value, intrinsic value, and moneyness.
Moneyness is a term to describe whether a contract is either “in the money”, “out of the money”, or “at the money”.
A call option is said to be “in the money” when the future contract price is above the strike price. A call option is “out of the money” when the future contract price is below the strike price.
DID YOU KNOW? - Approximately 20% of the total volume at CME Group is Options Volume. This is impressive given that options have been around only about 35 years while futures have a much longer history—150 years.
For a put option, the contract is said to be “in the money” when the future contract price is below the strike price, and “out of the money” when it is above the strike price. The term “at the money” refers to the strike that is closest to the underlying futures contract. When this happens both the call and the put option will be “at the money” at the same time.
The terms “in the money” and “out of the money” refer to the option contract itself and do not represent the profitability of your trade, nor does it depend on whether you have bought or written the option.
Time Value & Intrinsic Value
When an option is in the money it is said to have intrinsic value, and when the contract is out of the money it has no intrinsic value. When an option expires out of the money, traders will say that contract has “expired worthless”. Intrinsic value is the value of the option if it expired at this moment.
Up to this point we described the value of an option contract at the point of expiration, but what is the value of the contract before expiration?
The value of an option is comprised of two parts, the intrinsic value and the time value. When added together, they give you the “option value”.
Option Value = Intrinsic Value + Time Value
When an option contract expires, the time value would be zero. At this point the option value is equal to the intrinsic value.
Option Value = Intrinsic Value + 0
Let’s look at an example when the option has time value greater than zero. Suppose a call option will expire in one month. Here the option value will be higher than the intrinsic value. Even as the futures contract price moves around, the option value will still be greater than the intrinsic value, and that difference is the time value.
As time moves towards expiration, the time value shrinks or decays. The time value of an option (before its expiration date) will always be greatest when the option is at the money.
You can see the entire option value will always be greater than the intrinsic value until it reaches expiration.
There you have it, you now know how to use terms like moneyness, time value, and intrinsic value to express the value a put or call option.
Understanding Options Expiration (Profit and Loss)
The profit and loss of an option position at expiration is a function of the original premium and the difference in price between the futures contract and the strike price of the option.
Selling a Call Scenario
Suppose you sell the 105 call for $2 in premium. The maximum profit potential for this trade is $2. Let’s look at a few different possible outcomes for the futures price at expiration.
To understand the profit and loss, we look at the math for each of these potential scenarios. You sold the option and collected $2 in premium. For each scenario the premium column will be $2 and the strike price is $105. This is the price at which you are obligated to sell the futures contract if you are assigned.
Sell Call Scenario One
In scenario one, the futures price at option expiry is $112. This option will be in the money and you would be assigned. You will sell the future for $105 creating an instantaneous $7 loss on the future. You collected $2 in premium and lost $7 on the future, so your net loss will be $5.
Sell Call Scenario Two
For scenario 2 we see the futures price at option expiry is $106. This option is also in the money and again you would be assigned. You will sell the future at the strike price of $105 and have a loss of $1 on the future. Since you collected $2 in premium you will have a net profit of $1.
Sell Call Scenario Three and Four
In scenario 3, the futures price at option expiry is $100. This option is out of the money and will not be exercised. There will be no loss from futures. Therefore, your $2 collected in premium will become your total profit.
Scenario 4 has the futures price at $94. This example is like scenario 3; the option will be out of the money and will not be exercised. Again, your final net position will be a profit of $2.
Buying a Call Scenario
Now let’s look at the same group of scenarios but from the buyer’s perspective.
In this case you buy a call at $105, and pay a $2 premium to the seller. We will look at your profit and loss potential using the same futures prices at option expiration.
Buy Call Scenario One
In scenario one, the futures price at option expiration will be $112. This option is in the money. You exercise the option at $105. With the futures at $112, this will result in a gain of $7. If you subtract the $2 premium paid for the option, your net profit will be $5.
Buy Call Scenario Two
For scenario two, the futures price at option expiration will be $106. Again, this option is still in the money. You exercise this option at $105 and make $1. You paid $2 in premium, so your net will be a loss of $1.
Buy Call Scenario Three and Four
Scenarios three and four are both out of the money options. In both cases you would not exercise the option. Your net loss has been capped at $2 which is the full premium paid for the option
These scenarios show you two views of profit and loss from either side of the same transaction. When looking at profit and loss potential of an option position at expiration, you will need to consider the original premium and the difference in price between the futures contract and the strike price of the option.
Introduction to Options Theoretical Pricing
Option pricing is based on the unknown future outcome for the underlying asset.
If we knew where the market would be at expiration, we could perfectly price every option today. No one knows where the price will be, but we can draw some conclusions using pricing models.
When looking at call options, a higher strike will cost less than a lower strike.
If the underlying asset price has risen dramatically and you chose a higher strike price rather than a lower strike, your payoff will be less because you have foregone the first part of the upward price movement.
To get an idea of how much the premium should be at each strike, we are going to use a simple model.
Assume an asset is priced at $100 and has the characteristic of moving one dollar each month (either up or down). In this model, we will assume the price movement repeats every month over the life of the option and the option expiration will occur in four months.
What is the probability for each of the possible price outcomes after four months? In this model there are 16 possible paths that lead to each of the five price outcomes. The probability of each outcome can be calculated by aggregating the paths for each price.
The probability of reaching any one price point in this model is the number of paths in that price point divided by the total number of paths.
Now that we have the probability for each price point, we can start pricing options with different strike prices. First, you need to know the payoff for each strike price at the defined price level.
For example, the 97 call with an underlying price level of 96, would be an out of the money option. The payoff is zero.
At a price level of 98, the 97 call is now in the money, and the payoff is $1. At 100, the payoff is $3, at 102 the payoff is $5 and at 104 the payoff would be $7.
To find the probability weighted payoff, we multiply the probability for each price point by the payoff amount. The theoretical price for a 97 call would be the sum of the probability weighted payoffs. In this case the sum would be 3.0625.
Continuing the mathematics for each strike price we see the 101 strike has a theoretical price of .4375 and the 103 strike has a theoretical price of.0625.
It should be no surprise the 103 strike has less value than the 101 strike as the probability of it being in the money is much less.
Traders use proprietary models to determine if the prices in the marketplace are in line with their views. We have shown you a very simple binomial model. Which assumes that the market will move a set amount, either up or down, over each period. Even the more advanced models still provide only estimates for the option price and are still based on assumptions about the future. These theoretical pricing models provide options traders the ability to track and measure option prices.
Discover Options Volatility
Understanding Options Volatility
Volatility is the bounciness of the underlying asset of an option.
There are complicated formulas for measuring realized volatility, there are complicated formulas for forecasting volatility, and there are also complicated formulas for calculating implied volatility.
Temperature Change Example
For example, we will look at temperature changes that may occur in different parts of the world. In Singapore, the temperature swings over the course of a year only vary by 15 degrees from the coldest temperature to the hottest. In Bismarck, North Dakota, those same temperatures swings can be as much as 80 degrees. Thus, the temperature volatility is much greater in Bismarck than in Singapore.
Asset Class Example
You can also compare the bounciness of natural gas prices to corn prices.
If we look at price changes in percentage terms for natural gas versus corn, we see the natural gas price change, whether up or down, is larger than the corn price change. Therefore, natural gas is bouncier than corn.
Volatility as Measure of Bounciness
Volatility as a measure of bounciness, is simply a standard deviation of the underlying asset.
In the options world, volatility is quoted as an annualized number. You can calculate a one year, one standard deviation move,by taking the volatility times the underlying price.
For example, if the underlying price was 100 and volatility was 20%, a one standard deviation move would be 20 points, up or down. This would create an expected price range of 80 to 120.
If you have a different time horizon, we can calculate that as well by adjusting the volatility by using the square root of time. For a one-month period, the standard deviation would be 20% times the square root of 1/12. The square root of 1/12 is 0.289. Therefore, the range from an initial price of 100 would be 94.2 to 105.8 in one month. For a one-week period, the standard deviation would be 20% times the square root of 1/52. A one standard deviation range for a week, would be 97.2 to 102.8.
The bounciness of an asset is referred to as volatility, which is the standard deviation. In the options world, that standard deviation is always annualized. The standard deviation can be scaled to different time periods.
We have demonstrated how you could compare the bounciness, or volatility, of different underlying assets by annualizing the standard deviations of those assets.
Put Call Parity
Individuals trading options should familiarize themselves with a common options principle, known as put-call parity.
Put-call parity defines the relationship between calls, puts and the underlying futures contract.
This principle requires that the puts and calls are the same strike, same expiration and have the same underlying futures contract. The put call relationship is highly correlated, so if put call parity is violated, an arbitrage opportunity exists.
The formula for put call parity is c + k = f +p, meaning the call price plus the strike price of both options is equal to the futures price plus the put price.
Using algebraic manipulation, this formula can be rewritten as futures price minus call price plus put price minus strike price is equal to zero f - c + p – k = 0. If this is not the case, an arbitrage opportunity exists.
For example, if the futures price is 100 minus the call price of 5, plus the put price of 10 minus the 105 strike equals zero.
Say the futures increase to 103 and the call goes up to 6. The put price must go down to 8.
Now say the future increases to 105 and the call price increases to 7. The put price must go down to 7.
As we originally said, if futures are at 100, the call price is 5 and the put price is 10. If the futures fall to 97.5, the call price is 3.5, the put price goes to 11.
If a put or call does not adjust in accordance with the other variables in the put-call parity formula, an arbitrage opportunity exists. Consider a 105 call priced at 2, the underlying future is at 100 so the put price should be 7.
If you could sell the put at 8 and simultaneously buy the call for 2, along with selling the futures contract at 100, you could benefit from the lack of parity between the put, call and future.
Look at different market outcomes demonstrating that this position allows individuals to profit by arbitrage regardless of where the underlying market finishes.
The futures price finished below 105 at expiration. Our short 105 put is now in-the-money and will be exercised, which means we are obligated to buy a futures contract at 105 from the put owner.
When this trade was executed, we shorted a futures contract at 100, therefore our futures loss is $5, given the fact that we bought at 105 and sold at 100. This loss is mitigated by the $8 we received upon the sale of the put. The put owner forfeited the $8 when he exercised his option.
Our long 105 call expires worthless, so we forfeit the $2 call premium. This brings our net profit to $1 with the loss of $5 from the futures and loss of $2 from the call and the gain of $8 from the put.
Another scenario, the futures price finished above 105 at expiration. Our long 105 call is now in-the-money allowing us to exercise the call and buy a futures contract at 105. Because we exercised the option, our $2 premium is forfeited.
When this trade was executed, we shorted a future at 100, therefore our futures loss is $5. The $8 we received from the sale of the put is now profit because it expired worthless. If you add up the $8 gain from the put, less the $5 loss from the futures and $2 loss from the call you would net a profit of $1.
If the futures end exactly at 105, both options expire worthless. We lose $5 on the futures and make net $6 in options premium, therefore, we net $1.
We stated earlier that put-call parity would require the put to be priced at 7. We have now seen that a put price of 8 created an arbitrage opportunity that generated a profit of $1 regardless of the market outcome.
Put-call parity keeps the prices of calls, puts and futures consistent with one another. Thus, improving market efficiency for trading participants.
Options on Futures vs ETFs
Understanding Options versus ETFs
Purchasing ETF options is one way to gain leveraged exposure to the broad equity market, but savvy traders also understand that options on futures are another way to gain similar exposure to the same market.
Trader expectations and needs;
Kraig and Caitlyn both expect the S&P 500 to make positive gains.
Both would like to limit their downside risk.
Caitlyn wants the ability to trade around the clock.
Both traders could meet their needs is by using options.
Each trader has a brokerage account worth $20,000.
Commit no more than $1,500 for this trade.
We will assume the market for the S&P 500 is currently at 2,300. Kraig considers buying an SEC regulated SPY option. Caitlyn is looking at a CFTC-regulated E-mini S&P 500 option, product symbol ES. Caitlyn knows about SPY options but she wants the ability to trade nearly 24 hours a day. After all, it is a global economy and market events can impact prices any time of the day.
With the S&P500 index at roughly 2,300, the SPY ETF is at 230. Each SPY option has a 100 share multiplier, so the notional value for each SPY option at 230 is;
100 X $230 = $23,000.
Kraig is looking at the Feb 230 call option on SPY, priced at $2.50. If he buys five options, it will cost him;
5 options X $2.50 X 100 = $1,250
The notional value for five SPYs;
5 X $23,000 = $115,000
E-mini S&P 500 Trader
With the S&P500 index at roughly 2,300, the ES future is roughly 2,295
(Equity index futures tend to trade at a slightly different price than the underlying index due to cost of carry)
Caitlyn is looking at the Feb ES options strike at 2,295. ES options settle into one ES future which has a $50 multiplier. So the notional value for each ES option is;
$50 (multiplier) X 2300 (index) = $115,000.
Assuming the equivalent Feb ES 2,295 call option is trading at $25. If Caitlyn buys one 2,295 call option, she spends;
$25 X 50 (multiplier) = $1,250
Both traders submit their orders and which are executed immediately.
Caitlyn had $20,000 in her futures account at her FCM. Her account will now show; $18,750.00 ($20,000 – $1,250) and long one ES Feb 2,295 call option.
Kraig’s account will show a similar balance of $18,750.00 ($20,000 – $1,250) and he is long five SPY Feb 230 call options.
In February when contracts expire, the S&P500 Index has risen to 2,400.
The futures are now trading at 2395 and the SPY is 240. At expiration Caitlyn’s option is “in the money” and exercised at 2295.
Caitlyn now owns one ES March future contract for which she paid 2295. The March futures is currently priced at 2395. That is a 100-point gain. If you multiply that by the $50 multiplier you get $5,000.
Add that to her existing account balance and you get a new account balance of $23,750. And she is still long one ES March future. Because Caitlyn now has a futures position, she will be required to post margin.
Assume the E-mini S&P500 futures requires initial margin of $5,280 per contract. The FCM will see that Caitlyn’s account has more than enough to cover the required margin. This leaves her with $18,470 excess capital.
Now look at Kraig’s position at expiration. With the SPY trading at 240, Kraig’s option is in the money and is exercised. He now must pay for 500 shares of SPY at 230 per share. Which costs $115,000.
Assuming his account is subject to 50% margin his account must have half of $115,000 or $57,500. His current account balance is $18,750, so he needs to borrow an additional $38,750.
Would you rather prepare to manage your next move with your excess capital or have to find additional funds to keep this trade alive?