Intrinsic options have strike prices that are in-the-money. If the December gold futures contract is trading at $690 per ounce, the December gold $670 call option is in-the-money, or intrinsic for $20. If the $670 call is trading at $32, $20 is the intrinsic value and $12 is the premium. The $12 also is what the December $670 put is trading for. Using the same month and strike, the call, the put, and underlying futures price have a definite relationship to price. If any of the three is out of line, there would be an arbitrage opportunity for a trader to take advantage of and lock in a profit no matter where the market goes. This is called reversals and conversions. If you are planning to enter a position on a futures contract and want to buy protection from unlimited losses with the purchase of an option — which would be two trades, two commissions, two entries and two exits — the same can be accomplished with the simple purchase of an intrinsic option.
If you are bullish you would buy a December ’07 gold futures contract at $690 and buy a December ’07 gold $670 put for $12. If right, this strategy can obtain unlimited profits minus the $12 paid for the put. If wrong and the market goes down, the most you can lose is $32: $690 - $670 = $20 loss on the futures, and $12 on the cost of the put equals $32.
If the market goes to $740 on expiration day; you would make $50 minus the $12 paid for the put, which is $38. If you exited before the expiration day with the market at $740, you would sell the futures and make $50, and you would sell the put for what it is worth (the more time until expiration, the more value) for let’s say $2. So you paid $12 and sold at $2, lost $10 — the $50 profit from the futures minus the $10 loss on the put equals a $40 profit.
If the market goes down to $680 at expiration, you lose $10 on the futures and $12 on the put for a total loss of $22. If before expiration and you sell the future at $680 and sell the put for lets say $14 (the more time until expiration, the more the premium for the put) you would lose $10 on the futures and gain $2 on the put for a total loss of $8. If the market is below $670 on expiration, the total loss is $32 (futures loss of $690 - $670 = $20, plus the $12 paid for the put equals a loss of $32. The intrinsic option mirrors that. Whatever results the above strategy of buying a futures and buying a put yields, the result of the intrinsic option strategy will be the same.
Instead, buy a December $670 call for $32 (it has $20 intrinsic value and $12 premium) with one entry, one exit and one commission. An intrinsic option will act just like a futures contract minus the premium paid if you are right the market. If wrong, you can only lose the amount paid for the option no matter how much the market moves against you. At $740 the December $670 call is worth $70: $70 - $32 paid equals a $38 profit, which is the same as above. If below $670, the most you can lose is the $32. If it’s before expiration, it would be the same profit or loss as the long futures with a put strategy.
The time decay of the premium inside the intrinsic option and the put option held to protect the futures contract is the same at the same strike. The loss of this premium and intrinsic value is usually less than the loss incurred if you used a stop on your futures position, and it buys you the time for a turnaround without the worry of further loss. This is well worth the expense. Instead of trading a future with a stop, where there is no guarantee you will be stopped out at your price in a volatile market, you gain better risk management and retain more opportunity. Intrinsic options will act more like a futures contract with more profit as you are right, and act less like a futures contract and lose less money in relation to a futures contract if the market goes against you.
There are many tradeoffs using options and all must be considered to determine the best strategy for each trade idea. The positive on this strategy is that the option acts more like a futures contract and manages time effectively. It allows you time to see if your idea is going to work or not with a known risk. The tradeoff is the premium paid on the option for protection. The risk of being stopped out, the built-in discipline, and the luxury of time with known risk, is well worth paying the premium in most cases.
Note: A full sized gold futures contract and its option is 100 oz. Every $1 is $100 in value: 100 oz x $1= $100. If the option costs $32, that is $3,200. If the futures make or lose $32, that is $3,200.
Howard Tyllas is currently a member of the Chicago Board of Trade and registered with the CFTC as a floor broker and CTA. He’s a member of the NFA and a veteran trader of 31 years. He has traded options on futures since their inception. www.howardtyllas.com.