Session 1, Lesson 6 / WHAT TO DO WITH AN OPTION -expire,exercise,offset

In this lesson we’re going to explore the three things that happen to an option after it is purchased. The buyer will either a) let the option expire, b) exercise the option; or c) offset the option. I’ll explain what each choice means, how it happens, and why you would select that choice. For our example, we’re going to use the case of a farmer who purchased a December put option in the middle of summer to protect his price of corn. We’ll assume that he purchased a December $2.60 corn put.

Working off the example that I just described, one thing that could happen to the option is that the trader could choose to let it expire. In defining options, we indicated that options are like an insurance policy in that they have a fixed life. An option is only good for a certain amount of time until it runs out. You buy insurance to give you coverage for a six-month or one-year time period, and when you buy an option, you also have protection for only a certain length of time.

In the case of this December put option example, we would be buying protection until about the third week of November. When the trader bought the December $2.60 corn put, he purchased the right to sell December corn futures at $2.60 any time before the expiration of that contract in November. In order to receive that option, he paid the premium to the seller. If corn prices were above $2.60 when the option approached expiration (November 15), the trader could simply choose to do nothing and let the option run out or expire. Many options simply do expire. If the price of corn were at $2.70 in November, the trader would easily choose to sell the corn at that better price and not use the right that he has to sell at $2.60. Keep in mind also that the seller of the option cannot force him to make a sale at that level. The option or the right is strictly the choice of the option buyer.

Looking at another example, if a trader had purchased $84 feeder cattle call options to hedge the needs of his feedlot and feeder cattle were actually at $80 at the time the option was ready to expire, he would choose to do nothing with his option and rather purchase on the cash market or buy futures at a lower price if he needed a continued hedge. To let an option expire, the trader or rancher in either example would simply do nothing. You do not have to call your broker or take any other action. If you choose to let the option expire, the last trading day will simply come and go and you should receive a statement from your brokerage firm indicating that the option has expired and the contract is now complete. You should have no additional fees or charges to pay at that time. It’s very similar to what would happen if you bought insurance on an automobile for six months, and when that insurance policy was ready to run out you chose not to renew it. The policy would simply lapse.

Another alternative to letting an option expire is to exercise the option. The word exercise as it applies to options means to turn the option into a futures contract. The basic definition of an option is that it is a contract which allows the buyer the right to buy or sell a futures contract (depending on whether a put or a call is purchased). When you exercise an option, you’re using that right to receive a futures contract. In the example of the trader who owns a December $2.60 corn put, if corn prices near expiration in November are trading at a level below $2.60, he could choose to exercise his option. As an example, let’s say that corn futures are currently trading at $2.40 at the time of expiration. To exercise the option, the trader would call his broker and instruct him to exercise that position. The broker in turn calls his clearing firm and they inform the clearing corporation of the need to have that option exercised.

The trader then would have a futures position in his account which would show him short December corn from $2.60. The option would be removed from his account, since it had been converted or exercised. Now some people will ask how the person can be given a short position at $2.60 when the market is actually trading at $2.40. An option exercise is not actually traded in the pit. For every futures contract, there must be a buyer and a seller, and that is also true when a futures position is created through the exercise of an option. The trader in our example is now short December corn from $2.60 and someone who sold that original put option gets a call from his broker saying that he is now long December corn from $2.60. If December corn futures are currently at $2.40 when this transaction takes place, our example trader has a profit in his account of 20 cents on the futures position. The seller of the option who receives the other side of this futures contract would show a loss in his account of 20 cents on the new position.

Keep in mind, of course, that the 20 cent “profit” that is showing up in the account of our example trader is not truly total profit, since there was an initial cost incurred to get into the option position. Bear in mind also that the brokerage house is likely to charge a commission for handling the exercise of the option. Options are exercised, but of the three things that can happen with an option, being exercised is the least common.

A very common outcome for an option is for it to be offset. The term offset means that after you have bought an option, you get out of it or offset it by selling it back. Who do you sell it to? Options are traded throughout the day and there are people in there constantly buying and selling. To offset your option, you are selling it back to anyone that would buy it and that may include local floor traders or another trader. Offsetting is the approach that we highly recommend and should be used the vast majority of the time. Here’s an example of how it would work. Let’s say that our example trader bought his December $2.60 corn put and paid 10 cents for it. If the market drops to $2.40 by November, that option might theoretically be worth about 23 cents. If the trader chooses to offset the option, he would simply sell it back for the 23 cents and receive that amount of money. In determining his profit, he would still need to subtract his commissions and the 10 cent premium that he originally paid. Some firms charge an additional commission to offset an option, while others do not.

ANSWERS TO ASSIGNMENT

On the assignment from lesson 5 we provided you with a table of futures prices. You were to determine if the options were in the money, at the money, or out of the money. The futures price as well as the answers are provided below.

Futures Price Answer

March Corn – $2.50 Mar 230 put — out-the-money / Mar 230 call — in-the-money / July Corn – $2.60 Jly 240 call — in-the-money / May Soybeans – $6.00 May 575 put — out-of-the-money / Jly 575 call — in-the-money / Mar Chi Wheat – $3.80 Mar 370 put — out-of-the-money / Feb Live cattle – $74 Feb 74 put — at-the-money / Feb 74 call — at-the-money / Feb Live hogs – $44 Feb 44 put — at-the-money / Feb 44 call — at-of-the-money

2. If an option is in-the-money, it has intrinsic value or cash value as part of the premium. True. / 3. An out-of-the-money option can never become in-the-money regardless of how much the futures move. 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.

ASSIGNMENT

1. If a buyer of an option chooses to sell back the option, he is choosing to do which of the option?

a. Exercise b. Expire c. Offset

2. If a trader buys a $56 hog put option and futures are above $60 when the option stops trading, the trader chooses to do nothing with his option. What has the trader decided to do with his option?

a. Have it expire b. Exercise it c. Offset it

3. A trader who originally bought a call option and has his broker convert it into a futures position has done what to that option?

a. Let it expire b. Exercise it c. Offset it

4. Which is the least common outcome for an option contract?

a. Expiration b. Exercise c. Offset

5. The buyer of a put option has the right but not the obligation to be short the futures at the strike price. True or False?

6. A call option gives the buyer of that option the right but not the obligation to be long the futures from a level equal to the current futures price minus the premium. True or False?

7. Jan soybeans are trading at $5.80, a Jan $6.00 soybean put is trading at 25 cents:

a. time value: ____________              /                  b. cash value: ____________

SUMMARY

— Once an option has been purchased, one of three things will happen later. The option will either expire, it will be exercised, or it will be offset. — The buyer of an option may choose to let the option expire if it has no value.  — A buyer of an option may choose to exercise or turn the option into a futures position if there is value in the option. He may do this by contacting his broker and giving him appropriate instructions.  — The buyer of an option can offset that position by selling back the exact same option. The option must be identical in terms of type (put or call), contract month and strike price.