“Knowledge rests not upon truth alone, but upon error also.” –Carl Jung
This quote by the philosopher Carl Jung epitomizes why I have chosen to write this educational blog on commodity options; in fact, I wonder if Jung hadn’t actually traded options before he wrote this pithy quote! In other words, the primary reason for this blog is simple: there is a sheer need for more education and dialogue related to the choice, implementation, and management of commodity options, it would seem to me. And I have been a registered commodities representative with a Series 3 license since 1995. I can tell you that I hear from hedgers and traders alike that, after 21 years of doing this, I hear nearly as many complain that commodity options have cost them money as I did when I first started as a commodity broker. Even with the advent of algorithmic trading systems and computer order-entry, the level of education most analysts and commodity traders have today is not much better than it was 20 years ago, if you ask me. And this is why the commodity options continue to carry such a negative bias with many investors/hedgers.
AND THIS IS WHY I’VE CHOSEN TO MAKE THIS BLOG FREE–IT IS, ABOVE ALL ELSE, AN EDUCATIONAL BLOG; ONE THAT IS TO ENCOURAGE AND STIMULATE THOUGHT AND INCREASE KNOWLEDGE.
I am hopeful that this blog will accomplish a few critical things as we move forward. First and foremost, to EDUCATE both current commodity investors as well as new ones. I feel very strongly that with the advent of computer-aided trading and algorithms, volatility in the financial markets–including commodities–will only increase. If I’m correct about this, the need to utilize known-cost options is going to increase. Why? Because simply buying or selling futures will not provide the needed risk management protection. A loss in futures, for example, can only be offset if you are a hedger; the hedger can’t make any more than that up in terms of revenue. More on this concept in a later blog.
Second, my goal in writing this blog is that the reader will agree with me about options in commodities being a superior tool for risk management, once these derivatives are understood and implemented with greater knowledge (AND THEREFORE LESS EMOTION). In fact, if you asked me (or my brokerage clients) what the #1 reason options haven’t worked for us, it is because the option strategy was not thought-out and implemented due to too much emotion and not enough knowledge. To me, it’s really that simple to succeed in trading/hedging options in the commodity markets.
[And important note here: I will only write about commodity options; I have no authority as a licensed broker to discuss financial options–only futures-related options are what I am able to discuss.]
Time Value Vs. Intrinsic Value in Options:
The diagram below comes from a handbook that is over 25 years old; that’s another great thing you’ll discover about this blog–I have saved many books, handbooks, journals, and articles related to commodity options. In addition to this, I have some of the latest, real-time option software that I will also utilize in the blog posts. Back to the diagram…
There are two concepts that start an option trader off on the right path or the wrong path, if you ask me: knowing what intrinsic value is vs. extrinsic value of a call and a put.
Ψ. But what about the difference between a call and a put? That’s simple. A call is the right to buy/take ownership of long futures, while a put is the right to sell/take ownership of short futures…IF YOU ARE A BUYER OF THE OPTION. Otherwise, you have no rights as a seller. Thus, if you sell a call, you are giving-up your right to be long: so you are short the futures. And the opposite would be true as a put seller: you forfeit the right to be short the market, so you are long futures. There are important differences that we will discuss later in a future blog, but let’s not over-complicate it now.
DID YOU JUST SEE THAT SPECIAL SYMBOL, POSEIDON’S TRIDENT IN RED ABOVE? That is your indication that there is an important point coming for you to understand options better. I’ll be using Poseidon’s “pitchfork” throughout this blog…OK, back to the intrinsic/extrinsic value discussion:
An option’s cost, or premium, is made-up of both intrinsic & extrinsic value, so that: Premium = intrinsic value + extrinsic value
- Intrinsic Value (or In-the-money): Built-in value, or the amount of difference between the option strike price and the underlying futures price.
- Extrinsic Value (or Out-of-the-money): Time-value. Nothing more, nothing less.
So, if we use the example of a November $12.00 Bean Put, with a premium of $1.07/bushel, and November Bean Futures = $11.60, that $12 strike price put has an intrinsic value of .40 cents, meaning that of the $1.05 premium, .40 cents is built-in value while the other .67/bu. is time-value/extrinsic value.
- The $12 Put is .40 cents over the November futures price, and this is why it has intrinsic value totalling .40 cents.
- The balance of the cost–which is 63% of the total mind you–is extrinsic value, or time value. It’s what you are paying the option seller to hold that option because he, unlike you, has unlimited risk.
Ψ. An option buyer of commodity options has only his/her premium paid at risk, no more. It is the exact opposite for an option seller: he/she can make no more than the premium and has unlimited risk or additional losses.
We’ll delve more into these value terms on the next blog, specifically:
(1) How these two terms can help you decide what strike price to buy or sell
(2) How these two terms help you implement your plan and manage your premium
General Risk Disclosure—There is substantial risk of loss in trading futures and options, therefore you should carefully consider whether trading is appropriate for you in light of your experience, objectives, financial resources and other relevant circumstances. The information above is not meant to be advice to buy or sell futures and options. Options Risk Disclosure—The purchaser of options should be aware that he could lose all premium paid for such options as well as any commissions and fees. Further, purchasing deep-out-of-the-money options have a remote chance of becoming profitable. The writer or seller of options should be aware that there is unlimited risk and could result in such seller being required to maintain a futures position with any associated liabilities for margin.Past performance is not necessarily indicative of future results Information Disclaimer—The information and data contained herein was obtained from sources deemed reliable. Their accuracy and completeness is not guaranteed. Any decision to purchase or sell based upon such information is the responsibility of the person authorizing the transaction. Prices could already have factored-into them the seasonality or cycles of the market. Copyright, 2016 Global Commodity Analytics & Consulting LLC