How do commodity options work?
How is the value of an option calculated?
First you have to understand the meaning of intrinsic and extrinsic. The premium option is made up of both values. Intrinsic is the value of the option if you exercised it on the futures contract and then offset it. For example, if you have a $ 5 November soybean call option and the futures price for that contract is $ 5.20, therefore, there is an intrinsic value of .20 for that option. Soy is a 5,000 bushel contract, so 20 cents times 5,000 = $ 1,000 intrinsic value for that option.
Now let’s say the same $ 5 soy call in November costs $ 1600 in premium. $ 1000 of the cost is intrinsic value and the other $ 600 is extrinsic. The extrinsic value is made up of the time value, the volatility premium, and the demand for that specific option. If the option has 60 days left until expiration, it has more time value than it would have with 45 days remaining. If the market has large low to high price movements, the volatility premium will be higher than in a small price movement market. If many people are buying that exact strike price, that demand can also artificially increase the premium.
How much will an option’s premium move relative to the underlying futures contract?
You can solve this by finding out the delta factor of your choice. The delta factor tells you how much the premium change will occur on your option based on the movement of the underlying future contract. Let’s say you think December gold will increase by $ 50 an ounce or $ 5,000 per contract at expiration. You bought an option with a delta factor of .20 or 20%. This option should earn approximately $ 1000 in premium value from the expected movement of the $ 5000 gold futures price.
Can an option speculator make a profit before the option has intrinsic value?
Yes, as long as the option premium increases enough to cover transaction costs such as commissions and fees. For example, you have a call for December corn of $ 3 and the December corn is at $ 270 / bushel and your transaction costs were $ 50. Let’s say your option has a delta of 20% and the futures market of December corn rises 10 cents / bushel to $ 2.80 / bushel. Corn is a 5,000 bushel contact, so 1 cent times 5,000 = $ 50. Your premium option will increase by about 2 cents = $ 100. Your breakeven point was $ 50, so you have a profit of $ 50 with no intrinsic value because you’re still penniless for 20 cents.
Investing in options and futures is very risky and only risk capital should be used. Past performance is not indicative of future results. Cash, options, and futures do not necessarily respond to similar stimuli in a similar way. There are no good exchanges guaranteed.
