Options (on futures)
When we traded in the futures, we were trading directly in the underlying commodity, based on a fixed contract, which determined
the amount of commodity and therefore the point value, the amount of profit or loss we would be making as the price of the commodity
changed. However to trade, we had to trade at the price that the commmodity was trading at. Thus if Gold is currently trading at
$1200/oz of Gold, we could only trade (buy or sell) at $1200 per ounce.
If I now go to the market and say "you know what, I am willing to buy Gold, but only if the price is $1180 or less" - well I can try to enter that transaction, but no one is going to sell it to me - to be able to buy, someone somewhere must be willing to sell to me and since there are other buyers willing to buy at $1200, the sellers are rather going to sell to them instead and I'll be left stranded.
But let's say that I had the "option" to buy Gold at $1180. Now if I had such an option, it would have been worth quite a bit - for I could immediately sell gold at $1200 then exercise my option to buy Gold at $1180 and make $20 per ounce profit (which at $100 / point = $2000 profit!!). If I had such a option.
Now someone thought about this and said: "well, why don't we create such an option?". Thus if I came to you and said "wouldn't it be nice if you had the option to buy Gold for $1180?"
"OK, if I am willing to give you that option - how much will you be willing to pay me for that option?"
Well.... how much WILL YOU pay for such an option?
It is easy to see that such an option, if it existed, would have been worth AT LEAST $2000! For you could immediately exercise your option and make $2000 of profit. If such an option existed, it would be selling for AT LEAST $2000. But if you could wait a week? Well Gold can do a lot of things in a week! In a week's time Gold may be trading at $1220 and suddenly if you can buy at $1180 you will be making $4000 instead of $2000!! Someone willing to give you such an option has to take this potential "risk" into account and charge you accordingly for it. Of course in a week the Gold price could also drop to $1180 and then your option is worth nothing - you can buy Gold anyway for $1180, you don't need an option to do it.
If such an option was possible, therefore, one would have to carefully consider how much such an option would be worth. Well, lo and behold, such an option is available and you wouldn't guess.. it is called...wait for it.. it is called AN OPTION !
(Do you realize I can now trade in the futures without entering the futures market!? If I have an OPTION, I can just sit and wait and see what the futures does.. if it moves in the wrong direction, I just do nothing, I wait.. But if it moves in the right direction, I exercise the right the option gives me and take profit, without me ever having traded in the futures or be exposed to the risk as the price went up or down)
Options is actually an insurance instrument. Let's say you are a business man in Australia. You get a large contract for a guy in
the United States. You calculate for this job you need to bill AUD$1,000,000. The AUD/USD exchange rate is 0.80. Thus you quote your
client US$800,000 for the job. It will take you six months to finish the work.
In the next 6 months you are exposed to currency exchange rate risk. If the USD continues to strengthen agains the AUD and trades at 0.70 in six months time, then when the client pays you your US$800,000, you will actually receive AUD$1,142,857.14 - no one is going to complain about that. But if the AUD strengthens against the USD, say to 0.95, in six months, then on completing the job you will receive US$800,000 = AUD$842,105.26 and your project profitability is at risk!
How do you protect yourself against this risk!? Well, you could approach your merchant bank and ask them "Can you protect me against the AUD/USD exchange rate rising above 0.80 in the next six months, total amount of US$800,000?" Now an AUDUSD futures contract is for an amount of US$100,000 worth of AUD. Thus you need 12 contracts. The bank will say: "Well, sir, we are willing to sell you twelve 0.80 strike AUDUSD CALL options for a consideration of US$2750 each, valid for 6 months". Thus your cost (the insurance premium you pay for your insurance policy) = 12 x US$2750 = US$33,000.
Let's advance 6 months. AUDUSD trades at 0.95. Your client pays you US$800,000. You sell 12 AUDUSD futures and immediately exercise your option to buy them back at 0.80. Your profit = 12 x (0.95 - 0.80)x$100,000 (point value) = $180,000. Minus your insurance premium cost = $147,000. You receive ($800,000 + $147,000)/0.95 = AUD$996,842.11. You have successfully insured yourself against the currency risk by taking out an insurance policy against it.
Of course if the currency went to 0.70 instead, your options would have been worth nothing (expired worthless) and you would have lost the $33,000 in insurance fees, but hey ($800,000 - $33,000)/0.70 = AUD$1,095,714.29! It was worth taking out the insurance!
The Other Party...
THIS IS VERY IMPORTANT: Most people, or websites, when explaining Options, conveniently leave out this important aspect. For any
transaction to take place, there must be two parties to the deal. If you buy, then there must be someone selling to you and if you sell,
then you must be buying from someone... You cannot just "go long", or "go short". If you go LONG, someone somewhere MUST go SHORT! And
vice versa - if you SHORT, someone out of necessity needs to go LONG for there to be a transaction. If you cannot find a willing partner
to the deal to take the opposite position, then no transaction is possible!
Thus in our business man (BM) vs. merchant bank (MB) example above, when AUDUSD was trading at 0.80, BM bought an option (twelve actually) from MB. BM went LONG the OPTIONS. MB went SHORT the OPTIONS. Six months later, the AUDUSD went up and was trading at 0.95. BM now did two things. (1) He went SHORT the FUTURES at 0.95. Since AUDUSD was trading at 0.95 at that moment in time there were plenty of buyers around and he had no problem finding someone (an arbitrary trader) to go LONG. (2) BM then exercised the right the option gave him and went LONG the futures at 0.80 - thus he bought at 0.80 and sold at 0.95, giving him US$15,000 profit per contract. BUT, in order for him to be able to go LONG the futures at 0.80, he had to find a willing seller, someone to go SHORT the futures, at 0.80!
With the AUDUSD trading at 0.95, who in his right mind will go SHORT at 0.80, immediately realizing a $15,000 loss? This of course has to be the MB!! MB, through shorting the option to BM six months ago, gave BM a GUARANTEE, a CONTRACT, that they will take the opposite position in the futures should it be necessary. Thus, although unwillingly, MB has no choice here. When BM decided to exercise his right and went LONG the futures at 0.80, MB had to go SHORT the futures at 0.80 - and eat the loss!
We always have to take this into account. There are always two parties to the deal! Thus, when you BUY AN OPTION, you gain a certain right.. you gain the right to exercise your option whenever you wish. However please note - you have the option to exercise! You DO NOT have an obligation to exercise! This is very important - you DO NOT HAVE TO exercise your right, you can choose not to - for example, you may sell your right off to someone else. The OTHER PARTY however, the one who sold you the option, they have no choice! If you decide to exercise they HAVE TO take the opposite position. They have an OBLIGATION to take the opposite position - IF you exercised your right!
WHAT are OPTIONS?
OK, with the background above we are now able to give you some definitions.
An OPTION is a contract entered into between two parties, the seller (options writer) giving the purchaser the guarantee that the purchaser may acquire the underlying futures at a pre-specified price (the option STRIKE PRICE, or just STRIKE), on or before a pre-specified date (the option EXPIRY DATE), if the purchaser so chooses. If the purchaser exercises the right that the option gives him(we say you EXERCISE the option), the seller will take the opposite position in the futures market.
Since an investor can take on one of two possible positions in the futures market - you could either LONG the futures or SHORT the futures, you get two different kinds of options:
A CALL option will, when exercised, give the owner of that option a LONG position in the futures at the option's STRIKE price. (The seller of the option will receive a SHORT futures position).
A PUT option will, when exercised, give the owner of that option a SHORT futures position at the option's STRIKE price. (The seller of the option will be given the opposing LONG futures position)
Investors giving out these "guarantees" does not do so for nothing! The buyer of the option (purchaser of the option, the guy who goes Long) will pay a certain PREMIUM - amount of money - to the seller (the guy who write, or created, the option, the party that goes Short the option). This premium is non-refundable. How do we determine the premium? We'll get to that, but mate, it is entirely up to you - if the premium charged is too high, don't buy it - or if you are the seller, charge whatever you like, if you charge too much no one is probably going to buy it from you, if you charged too little, you'll soon know..
We have seen that the futures expires at a certain point in time - it has to, there needs to be a point in time when physical exchange of the commodity has to take place. Before that date there is the last trading day which is the last day when futures speculators had to wrap up their positions and get out of the market. Now, since the option is going to give you a futures, it makes sense that you HAVE TO acquire that futures before the last trading day, otherwise, what's the point? And you probably need some time to decide what you want to do with the futures, thus you need some time to trade your newly acquired futures and do something with it. Therefore Options Expiry Date is a date somewhere prior to the futures last trading day, (typically two weeks to a couple of days before), when the option will expire. Owners of options have to exercise their options, if they choose to, on or before options expiry date. Under certain conditions - we'll discuss below - the Exchange will automatically exercise all un-exercised options at close of business on the options expiry date. (Note that for each futures, the Exchange determines the options expiry date by a set of published rules, thus you do not have to worry about it, you only need to take notice of when that date is).
The strike price is the price specified by the option at which the futures transaction will take place. The strike price may be any price, either below, at, or above the futures' trading price. Usually in fixed increments - thus for Gold there is a strike at every $5 increments. For Crude Oil there are strike prices at every $0.5 increments. The strike that you want to trade at is up to you and the premium you are going to pay for the option depends on where the futures is trading relative to the strike. If you are willing to pay the premium charged, you are free to purchase an option at any strike.
Only the owner of the option - the party that is LONG the option, the purchaser of the option - has the right (note, a right, a choice, the
option to) - to exercise the option. It is a right, an option. It is not an obligation - you do not have to exercise your option. Exercise
is a simple act of going to your broker and informing him that you would like to exercise the option you have. You will immediately receive the
futures position at the STRIKE price specified by the option. And that is it - you no longer have an OPTION, you now have a FUTURES which you
have to manage the way you see fit.
What about the other party? Well first off, like with the FUTURES, the Exchange has got no way of tracking who is on which side of the OPTION as it changes hands from one investor to the next. When a speculator decides to EXERCISE and gets his FUTURES position, someone somewhere MUST necessarily get the opposite position in the FUTURES market. Who will be that person if the Exchange is unable to track the different parties to an OPTION as the option changes hands? It is simple - the Exchange will assign the other party AT RANDOM from out of the pool of SHORT OPTIONS holders for that Strike Price Option! NOTE: AT RANDOM !! Also Note: The "other party" has no say in this - the day he wrote an option (went Short the Option) he gave a GUARANTEE that we will take the opposite position. He has an obligation to fullfill the guarantee he has given. It is just his luck that he was the one chosen at random to be the other party to the exercise. When he (or she) next logs onto his trading platform he'll just see "huu..where's my option?" Instead he will have a FUTURES POSITION to manage as he (she) sees fit.
What happens on expiry date. More specific, at close of business on that day? We know that all options have to be resolved, they cannot
exist, or be further traded, after this day.
The Exchange will apply a few simple rules.
For all CALL options: If the price of the futures trades above the strike price of the option then there is value in the futures position that will result. All these options are exercised AUTOMATICALLY! If the price of the futures trades at or below the option's strike, there is no value in the position and these options EXPIRE WORTHLESS.
For all PUT options: If the price of the futures trades below the strike price of the option, there is value in the futures position that will result and these options are all exercised! If the price of the futures trades above the strike of the option, there is no value in the futures position and these options EXPIRES WORTHLESS.
Expiring Worthless - There is no value in these options. They cannot continue to exist after the last day and they just expire - they just stop to exist! They are just gone, finish, end of story. What about the premium that was paid for it? What about it? It was money that the buyer paid to the seller for the seller taking the risk. The seller keeps the premium - it is non-refundable.
To wrap it up..
An OPTION is an insurance instrument. It is a contract that a seller sells to a buyer that: (1) specifies the price at which they will transact (STRIKE) and (2) specifies the date up to when the contract is valid (EXPIRY DATE). The buyer pays a pre-determined (negotiated between the two parties), non-refundable premium to the seller for the seller being willing to take this risk and give the buyer the option. The option gives the buyer a right to exercise when and if he wishes, but binds the seller with an obligation to take the opposite position in the market when the buyer exercises. At option expiry date, if the buyer has not yet exercised his option, but only if there is value in the option, the Exchange will automatically exercise all outstanding options. If no value in it the options (contracts) will just expire.
Determining OPTIONS VALUE
We did not discuss this important aspect above. How do we know how much an option is worth? How do we determine the premium to be paid for the option?