basic options - opt 101

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

Exam

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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



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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



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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”

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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”

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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



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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



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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



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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)



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Right Right

Obligation ObligationObligation

Option Overview – Part 1Basic Definitions


Call Put

Option Contract

Buy

SellOpt

ion

Tra

de

The Right or The Obligation

Right Right

Obligation

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Basic Definitions




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Option Overview – Part 2Basic Definitions


Call Put

Option Contract

Buy

SellOpt

ion

Tra

deLong Short

Short Long

Long Short

Short Long

Long or Short Underlying Futures?

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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



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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



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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



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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



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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



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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”)



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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.)



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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



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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



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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



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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



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



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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)



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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)



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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)



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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 = ∞

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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)

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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)

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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

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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)

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Table of Contents


Basic Definitions




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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 options - opt 101

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