Options on futures: calls, puts, premium, intrinsic and time value
So far you have traded futures, where both sides are locked in: the buyer must buy and the seller must sell. An option is different. It gives one side a right, and the other side an obligation. In this track, the thing you get the right to is a futures contract, so these are called options on futures (the CFTC glossary calls them “futures options”: an option on a futures contract).
Calls and puts
There are only two kinds of option.
- A call gives the buyer the right, but not the obligation, to buy: on a futures option, to enter a long futures position at a set price.
- A put gives the buyer the right, but not the obligation, to sell: to enter a short futures position at a set price.
That set price is the strike price (also called the exercise price). Every option also has an expiration date, the last day it can be exercised.
Two sides: holder and writer
For every option buyer there is a seller.
- The buyer (the holder, or “long” the option) pays money up front and gets the right.
- The seller is called the writer or grantor. In return for that money, the writer stands ready to sell futures (on a call) or buy futures (on a put) if the holder exercises.
The money the buyer pays the writer is the premium. CME compares it to an insurance premium: the writer is being paid to take on risk.
Only the holder decides whether to exercise. When a holder exercises, the clearinghouse picks a writer to fulfill the obligation. That is called assignment, and CME Clearing does it at random among the writers. The result is always a futures position at the strike:
| Position | What happens | You end up |
|---|---|---|
| Long call | You exercise | Long futures at the strike |
| Short call | You are assigned | Short futures at the strike |
| Long put | You exercise | Short futures at the strike |
| Short put | You are assigned | Long futures at the strike |
Moneyness: in, at, or out of the money
“Moneyness” compares the strike with the current futures price.
- A call is in the money when the futures price is above the strike, and out of the money when it is below.
- A put is in the money when the futures price is below the strike, and out of the money when it is above.
- At the money is the strike closest to the futures price. CME notes that the call and the put at that strike are both at the money at the same time.
One trap: in the money describes the option itself, not whether your trade is making money. A buyer can hold an in-the-money option and still be losing, because of the premium paid.
Premium = intrinsic value + time value
CME splits an option’s value into two parts:
Option value (premium) = intrinsic value + time value
Intrinsic value is what the option would be worth if exercised right now: how far it is in the money.
- Call intrinsic value = futures price minus strike (zero if that is negative).
- Put intrinsic value = strike minus futures price (zero if that is negative).
An out-of-the-money option has no intrinsic value. Intrinsic value is never negative.
Time value (also called extrinsic value) is the part of the premium above intrinsic value:
Time value = premium minus intrinsic value
The CFTC glossary says time value reflects the probability that the option will move into the money before it expires, so the longer the time left, the greater the time value. CME adds that time value shrinks (decays) as expiration approaches, is greatest when the option is at the money, and is zero at expiration. At expiration, the option is worth only its intrinsic value.
Worked example (made-up numbers)
These numbers are invented for practice. They are not market prices.
Futures are trading at 100.00. You look at four options:
| Option | Premium | Intrinsic value | Time value |
|---|---|---|---|
| 95 call | 6.50 | 100 minus 95 = 5.00 | 6.50 minus 5.00 = 1.50 |
| 105 call | 1.25 | 100 minus 105 is negative, so 0 | 1.25 minus 0 = 1.25 |
| 105 put | 6.00 | 105 minus 100 = 5.00 | 6.00 minus 5.00 = 1.00 |
| 100 put | 2.50 | 100 minus 100 = 0 | 2.50 |
Notice:
- The 95 call and the 105 put are in the money, so part of their premium is intrinsic value.
- The 105 call is out of the money: its whole premium is time value.
- The 100 put is at the money: no intrinsic value, all time value.
Now jump to expiration with futures still at 100.00. All the time value is gone. The 95 call is worth 5.00, the 105 put is worth 5.00, and the 105 call and 100 put expire worthless.
Risk for each side
The CFTC’s required options disclosure (17 CFR 33.7) spells out the basics:
- A buyer can lose the entire purchase price: the premium plus all transaction costs.
- A writer should not grant an option unless able to meet margin calls and sustain a very large loss.
- Exercising an option on futures creates a futures position, so both sides should understand the underlying futures contract too.
The next lesson turns this into numbers: breakeven, maximum gain and maximum loss for common option positions.
Key ideas
- A call is the right to go long futures at the strike; a put is the right to go short futures at the strike.
- The buyer pays the premium; the writer (grantor) receives it and accepts the obligation.
- Only the buyer exercises; the clearinghouse assigns a writer at random.
- Call in the money: futures above strike. Put in the money: futures below strike.
- Premium = intrinsic value + time value. Intrinsic value is never negative; time value is zero at expiration.
- Out-of-the-money options are all time value.