Fundamentally, an option premium reflects two components: “intrinsic value” and “time value.” A number of mathematical models are employed to identify the fair value of an option notably including the Black-Scholes model.
Premium = Intrinsic Value + Time Value
The purpose of this section, however, is not to describe these models but to introduce some of the fundamental variables which impact upon an option premium and their effect.
The intrinsic value of an option is equal to its in-the-money amount. If the option is out-of-the-money, it has no intrinsic or in-the-money value. The intrinsic value is equivalent, and may be explained, by reference to the option’s “terminal value.” The terminal value of an option is the price the option would command just as it is about to expire.
When an option is about to expire, an option holder has two alternatives available to him. On one hand, the holder may elect to exercise the option or, on the other hand, may allow it to expire unexercised.
When an option is about to expire, it is either in-the-money and exercisable for a value reflected in the difference between market and strike price or, it is at- or out-of-the-money and has zero intrinsic value.
As such, the issue revolves entirely on whether the option lies in-the-money or out-of-the-money as expiration draws near. If the option is out-of-the-money then, of course, it will be unprofitable to exercise and the holder will allow it to expire unexercised or “abandon” the option. An abandoned option is worthless and, therefore, the terminal value of an out-of-the-money option is zero. If the option is in-the-money, the holder will profit upon exercise by the in-the-money amount and, therefore, the terminal value of an in-the-money option equals the in-the-money amount.
An option contract often trades at a level in excess of its intrinsic value. This excess is referred to as the option’s “time value” or sometimes as its “extrinsic value.” When an option is about to expire, its premium is reflective solely of intrinsic value. But when there is some time until option expiration, there exists some probability that market conditions will change such that the option may become profitable (or more profitable) to exercise. Thus, time value reflects the probability of a favorable development in terms of prevailing market conditions, which might permit a profitable exercise.
Generally, an option’s time value will be greatest when the option is at-the-money. In order to understand this point, consider options that are deep in- or out-of-the-money. When an option is deep out-of-the-money, the probability that the option will ever trade in-the-money becomes remote. Thus, the option’s time value becomes negligible or even zero.
An option’s extrinsic value is most often referred to as time value for the simple reason that the term until option expiration has perhaps the most significant and dramatic effect upon the option premium. All other things being equal, premiums will always diminish over time until option expiration.
In order to understand this phenomenon, consider that options perform two basic functions – (i) they permit commercial interests to hedge or offset the risk of adverse price movement; and (ii) they permit traders to speculate on anticipated price movements. The first function suggests that options represent a form of price insurance. The longer the term of any insurance policy, the more it costs. The longer the life of an option, the greater the probability that adverse events will occur … hence, the value of this insurance is greater. Likewise, when there is more time left until expiration, there is more time during which the option could potentially move in-the-money. Therefore, speculators will pay more for an option with a longer life.
Read more about “Other Factors”
Posted in CME Group, Strategy Tagged with: Call Option, Intrinsic Value, Options, Premium, Put Option, Time Value
CME Group’s Exchanges have offered options exercisable for currency futures dating back to 1982. Like the Exchange’s family of currency futures products, these options may be used as an effective and efficient tool to manage currency or FX risks in an uncertain world.
The purchase of an option implies limited risk and unlimited potential reward. The sale of an option implies limited reward and unlimited risk.
This post is intended to provide an overview of the mechanics of options on currency futures. Note that options contemplate the establishment of a currency futures position. These contracts are accessible through the CME Globex electronic trading platform.
What is an Option?
Options provide a very flexible structure that may be tailor made to meet the risk management or speculative needs of the moment. Options may generally be categorized as two types: calls and puts … with two very different risk/reward scenarios.
Two Types of Options
Call options convey the right, but not the obligation, to buy a specified quantity currency at a particular strike or exercise price on or before an expiration date. One may either buy a call option, paying a negotiated price or premium to the seller, writer or grantor of the call; or, sell, write or grant a call, thereby receiving that premium.
Buying a call is a bullish transaction; selling a call is bearish.
Put options convey the right, but not the obligation, to sell a specified quantity currency at a particular strike or exercise price on or before an expiration date. Again, one may buy or sell a put option, either paying or receiving a negotiated premium or price.
European-style vs American-style
Options may be configured as European- or American-style options. A European-style option may only be exercised on its expiration date while an American-style option may be exercised at any time up to and including the expiration date.
Profit/Loss for Call Option
The purchase of a call option is an essentially bullish transaction with limited downside risk. If the market should advance above the strike price, the call is considered “in-the-money” and one may exercise the call by purchasing currency at the exercise price even when the exchange rate exceeds the exercise price. This implies a profit that is diminished only by the premium paid up front to secure the option. If the market should decline below the strike price, the option is considered “out-of-the-money” and may expire, leaving the buyer with a loss limited to the premium.
Option buyers pay a premium to option sellers to compensate them for assuming these asymmetrical risks.
The risks and potential rewards, which accrue to the call seller or writer, are opposite that of the call buyer. If the option should expire out-of-the-money, the writer retains the premium and counts it as profit. If, the market should advance, the call writer is faced with the prospect of being forced to sell currency when the exchange rate is much higher, such losses cushioned to the extent of the premium received upon option sale.
Profit/Loss for Put Option
The purchase of a put option is essentially a bearish transaction with limited downside risk. If the market should decline below the strike price, the put is in-the-money and one may exercise the put by selling currency at the exercise price even when the exchange rate is less the exercise price. If the market should advance above the strike price, the option is out-of-the-money, implying a loss equal to the premium.
Buying a put is a bearish transaction while selling a put is a bullish transaction.
The risks and potential rewards, which accrue to the put writer, are opposite that of the put buyer. If the option should expire out-ofthe-money, the writer retains the premium and counts it as profit. If, the market should advance, the put writer is faced with the prospect of being forced to buy currency when the exchange rate is much lower, such losses cushioned to the extent of the premium received upon option sale.
Read more about “Option Pricing”
Posted in CME Group, FX, Strategy Tagged with: Futures, FX, Options, Risk Management
Globex is an electronic trading platform offering global connectivity to the broadest array of futures and options across all asset classes, traded in thousands of possible expirations and combinations.
CME Globex is the first derivatives platform to offer global access to all major asset classes—interest rates, equity indexes, FX, agriculture, energy, metals, weather and real estate.
Anyone who has an account with a Futures Commission Merchant (FCM) or Introducing Broker (IB), who in turn has a CME Clearing guarantee, can trade on the platform.
Read more of this article »
Posted in CME Group, Technology Tagged with: Electronic Trading, FIX Protocol, Futures, Globex, Options, Risk Management
An interactive options analytics tool where users can analyze open interest and open interest change patterns for each expiration within the selected product. Read more of this article »
Posted in CME Group, Tools Tagged with: FX, Indexes, Metals, Open Interest, Options