Lesson 1: Puts & Calls

This lesson is designed to cover the basic points of an options contract before moving ahead to advanced assignments. At the end of this lesson, you will be able to understand what an option contract represents and how to calculate the price, risk, and profit potential for any option.

To refresh, a futures contract is a specific agreement for the delivery (or cash settlement) of a commodity or financial instrument at some point in the future at a specified price. Each contract has a delivery month and, once that month is available to trade, the price may change (go up or down) at any point during trading hours.

To have a position in a futures contract market, a trader may take the buy (long) or sell (short) side of a contract for a particular delivery month. To close this position, the opposite action must be taken. A long position must be offset with a sell and a short position offset with a buy. The difference between the buy and sell prices represent the loss or gain on the contract.

Each futures contract price quote is relative to the commodity or financial instrument it is derived from. For example, grains such as corn or wheat are measured in bushels therefore the price quote is given in dollars and cents per bushel, with the smallest price fraction (minimum tick) being ¼ cent. It can be even trickier since some quotes and displays will show the fraction as a number 2, 4, 6, or 0, suggesting that the denominator is an 8. Therefore, 2 is really 2/8 or 1/4. 4 is 4/8 or 1/2. Crude oil is counted in barrels, so the contract is quoted in dollars and cents per barrel with each contract representing 1,000 barrels.

Contract size and price quotes are different for each market and the following chart is a quick reference for the more common markets. Sometimes, the minimum tick value can make for difficult or complicated math and it is easier to try to find a whole point value to use as a multiplier for fast calculations. The last column on the chart lists some of these whole point values. It can be confusing at first, since there are so many variations, so print and keep this chart as a handy reference for future lessons:

Contract	Size	Minimum Fluctuation	Whole Point Multipliers
Crude Oil	1,000 barrels	$.01 per barrel = $10.00
Corn	5,000 bushels	$.0025 per bushel = $12.50	1 cent = $50
Wheat	5,000 bushels	$.0025 per bushel = $12.50	1 cent = $50
Soybeans	5,000 bushels	$.0025 per bushel = $12.50	1 cent = $50
Euro Currency	125,000 €	$.01 per € = $12.50
Cotton	50,000 pounds	$.0001 per pound = $5.00
Coffee	37,500 pounds	$.0005 per pound = $18.75	1 cent = $375
Orange Juice	15,000 pounds	$.0005 per pound = $7.50	1 cent = $150
Gold	100 troy ounces	$.10 per troy ounce = $10.00
Sugar	112,000 lbs	$.0001 per pound = $11.20
Silver	5,000 troy ounces	$.005 per troy ounce = $25.00	1 cent = $50

Options are derivatives: Contracts based on the value and specifications of an asset. An option on a futures contract will specify the kind of option, a call or a put; the “underlying” futures market, such as corn, crude oil, or gold; the delivery month; the strike price; and the expiration date.

A call option gives the buyer the right to be long a futures contract from the specified strike price. A put option is the right to be short the futures contract from the strike price. Acting on this right is “exercising” the option. It is important to know that only buyers may choose to exercise an option. The option contract does not obligate the buyer to exercise, it simply allows the choice.

Market moves may negate any financial benefit to acting on the right to exercise. For a call option, if the futures price is below the strike price of the option there is no financial benefit to exercise. With a put option, the buyer would not choose to exercise if the price of the underlying futures is higher than the strike price. While there is no financial benefit to exercise, an option is said to be “out of the money.” If an option expires “out of the money,” it is referred to as “worthless.”

The expiration date for an option is the last possible day on which the option contract may be exercised or traded.

The price a buyer of a call or put pays for the option contract is referred to as the “premium.” Option premium is quoted in the same price increments as the underlying futures.

The strike price of the option is quoted a little differently. Normally, the strike price is displayed in a format that echoes the futures price. However, each market will specify incremental moves for the contracts. To simplify, crude oil is priced in dollars and cents per barrel. It would be far too complicated to have an option contract for every possible price, in dollars and cents, between $0 and the current market price. The available option contracts may have 1 dollar increments and be displayed as just the whole number: 80, 81, 82, 83, 84, etc. Here is a quick reference for some common displays for strike prices:

Market	Futures Price written as:	Nearest Strike Price could be written as:
Crude Oil	80.00	80
Corn	6.25 ¼ or 6252	625
Coffee	118.10	118
Orange Juice	74.15	74
Cotton	75.00	75

Let’s examine the following gold call option:

Dec10 Gold 1100 call @ 5.0

Dec10 refers to the December 2010 futures contract.

Gold is the market.

A call option is the right to buy the futures at the strike price.

The strike price is 1100 or $1,100 per ounce.

The premium is 5.0 with the last digit in the premium quote for gold referring to the decimal. A .10 move in gold is equal to $10 so one whole point (or dollar) move is worth $100. Therefore, the option premium of 5.0 is $500.

If the December 2010 gold futures contract rises above $1,100 before the option’s expiration date, the option is said to be “in the money.” In effect, if the owner of the option exercised his right to be long futures from $1,100, he could immediately offset by selling the December futures contract while it is trading at a price higher than $1,100.

An option which is “in the money” has “intrinsic value.” Options may also have “time value” ahead of their expiration date. Basically, an out of the money option with plenty of time until expiration can still have dollar value. This is because in the time until that expiration, the option could gather intrinsic value as the futures price moves.