Session 1, Lesson 5 / Strike Prices

STRIKE PRICES

In deciding to purchase an option, several choices must be made. In addition to knowing what commodity you are trying to hedge, you must also decide what contract months to use. Once you’ve decided on the contract month (and that decision will be based on your trading plan), you then decide whether you will be buying a put or a call. If you are trying to protect yourself from a decline in prices, you would consider purchasing a put option. If you were concerned about rising prices, a call option could be purchased. The decisions don’t stop there though. You have many strike prices available for each contract month for both puts and calls.

We will define a strike price as being the price that your option allows you to buy or sell at. As an example, if you bought a May 250 corn put, you have the right, but not the obligation, to sell May corn futures at $2.50. If you purchased a Jan 82 feeder cattle call, you have the right, but not the obligation, to buy Jan feeder futures at $82. It is important to know that your right, or option, is valid regardless of where the futures market is currently trading at. As an example, in the case of the May 250 corn put, if May corn futures were trading at $2.30 and you owned the $2.50 put, you would still have the right through that option to have a short position, or to sell May corn futures, at $2.50. This would be the case even though the futures market is trading at $2.30. Clearly, this would be an excellent position to be in.

Unlike premium, the strike prices are set by the exchanges. When a new contract month begins trading, normally you will find a strike price very close to the current futures price, plus usually two strike prices above and below that level. Strike prices are at fixed levels. In the case of corn, strike prices are every 10 cents on the even dime. For example, corn strike prices would be listed at $2.30, $2.40, $2.50, etc. Wheat follows that same pattern. Soybeans, however, have strike prices every 25 cents. For example, soybean strike prices would be $6.00, $6.25, $6.50, etc. The strike price really identifies that unique option contract. While the strike price does not vary, the premium – of course – does. A person must determine which strike price is most appropriate for their situation.

The importance of selecting the right strike price should not be underestimated. I have too often seen traders have a good trading plan and the right idea, only to meet with disappointment because they selected the wrong strike price. As we look at strategies in a future lesson, we’ll help determine which is the best to choose.

Three terms that are often used when it comes to strike prices and options are the terms “in-the-money”, “at-the-money” and “out-of-the-money”. When an option is said to be at-the-money, that means that the strike price is at, or nearly at, the same level as the futures price. For example, if July corn futures are trading very near to $2.40, a July $2.40 corn put or call would be considered roughly at-the-money. In our last lesson, we learned how to determine the amount of cash value or intrinsic value in option premium. If an option has intrinsic value or cash value in its premium, the option is said to be in-the-money. If it has no cash value (cash value equals 0), the option is referred to as out-of-the-money. As an example, if Feb hogs are at $43.00, then a Feb $44 put option would be in-the-money because it has $1.00 of cash value in the premium, while a Feb $42 put option would be out-of-the-money, having no cash value. There will be several examples to work on in your assignment for this lesson.

Example: If July soybean futures are at $6.00,

Puts                     Calls
650   in-the-money        550
625   in-the-money        575
600   at-the-money        600
575   out-of-the-money    625
550   out-of-the-money    650

ANSWERS TO LESSON 4 ASSIGNMENT

1. This was the table provided in lesson 4

Futures                             Options
Mar corn             226-1/2       Mar 240 corn put             15-1/4
Jan soybeans         568           Jan 575 bean put             12-1/2
Mar Chicago wheat    374-1/2       Mar 360 wheat put            7-1/4
Feb live hogs        4425          Feb 44 live hog put          115
Feb live cattle      7387          Feb 72 live cattle put       67
Jan feeder cattle    8357          Jan 82 feeder cattle call    227

2. Using the above table you were to determine the cash value, time value, and total premium. The answers are provided below.

Cash value        Time value    Total Prem
(a)               (b)          (a & b)
Mar 240 corn put      13-1/2             1-3/4         15-1/4
Jan 575 bean put         7               5-1/2         12-1/2
Mar 360 wheat put        0               7-1/4          7-1/4
Feb 44 live hog put      0                115            115
Feb 72 live cattle put   0                 67             67
Jan 82 fdr ctl call     157                70            227

EXPLANATION TO ANSWERS FOR LESSON 4

Question 2 needs a little explanation. The second problem was to figure the cash value and time value for a January 575 bean put. The easiest way to do this is to first fill in the last column of total premium. This column is the same as the information recorded in number one. For the January 575 bean put, total premium is 12-1/2 cents. The next step is to determine cash value. In this case we would find the answer by taking our January 575 put strike price, which gives us the right to sell January at $5.75, and subtracting the current price of the January futures which are trading at $5.68. The difference between the two is 7 cents. That 7 cents equals cash value. Having determined cash value, we now subtract that amount from the total premium, and whatever is left is always the time value. In this case the time value is 5-1/2 cents. Time value always equals option value minus the intrinsic value.

The next example gives us a different type of problem. In this case, total premium for the March 360 wheat put was 7-1/4 cents. You should also know that, unlike grain futures which trade in 1/4 cent increments, options trade in 1/8 of a cent increments. The cash value of the option then is determined by taking the 360 put with the right to sell at $3.60 and looking at the current futures price, which is $3.74-1/2. If you sold at $3.60 and bought at $3.74-1/2, not only would you not have a positive cash value but you would be loosing. Cash value can never go below 0, therefore, the value in this example is 0. Subtracting 0 from total premium shows that time value then equals 7-1/4 cents. The rest of the page can be done in the same manner.

ASSIGNMENT

1. Based on the listed futures price, please indicate if the option is in-the-money, at-the-money, or out-of-the-money:

Futures Price

March Corn – $2.50    Mar 230 put  ——————–
Mar 230 call ——————–
July Corn  – $2.60    Jly 240 call ——————–
May Soybeans-$6.00    May 575 put  ——————–
Jly 575 call ——————–
Mar Chi Wheat-$380    Mar 370 put  ——————–
Feb Live cattle-$74   Feb 74 put   ——————–
Feb 74 call  ——————–
Feb Live hogs-$44     Feb 44 put   ——————–
Feb 44 call  ——————–

2. If an option is in-the-money, it has intrinsic value or cash value as part of the premium. True or False?

3. An out-of-the-money option can never become in-the-money regardless of how much the futures move. True or False?

4. At-the-money options have more time value in the premium than either in-the-money or out-of-the-money options. True or False?

SUMMARY

— Selecting the right strike price is very important to a successful trading program.
— Strike prices do not change and are set by the exchanges, though additional strike prices may begin trading as the market moves and warrants.
— An option with intrinsic value in its premium is referred to as in-the-money.
— An option with a strike prices approximately equal to the futures price is considered at-the-money.
— An option with a cash value or intrinsic value of 0 is referred to as out-of-the-money.