"Calls on crude oil futures" (below) shows options on September 2011 crude oil futures on June 14, 2011. With the underlying at $100.40, the option price curve increases as strike prices are reduced. Each option price is determined by the upper and lower break-even prices that the market uses to define the price curve. As the strike price increases relative to the underlying, the lower break-even increases more slowly than the upper break-even price because the intrinsic value line slopes down in the same direction.
The delta value, or slope, at the point on the option price curve where the underlying equals the strike price, is approximately 0.5. This means that two calls could offset the price change of one futures contract — a fundamental requirement of the delta trade. The market is pricing September 2011 crude oil call options, with 64 days to expiration, based on upper and lower delta trade break-even prices of approximately 112 and 92. A call at 112 is listed with a premium of $1,260 while a put at 92 is $2,080 at the close of trading on
June 14, 2011.
The trade possibility — buying a call at or near the upper break-even and buying a put at the lower break-even — depends on the market’s logic and accuracy in establishing the break-even prices. For options to be priced for trading, the market must believe that profitable price variations are possible, and even likely. Thus, the upper and lower break-even prices on which option valuation depends should not be viewed as extreme limits that have low probability of being achieved. Instead, these are prices that the market views as entirely possible within the number of days to expiration.
Recent price volatility plays a large role in determining the range of forward break-even prices, and fundamental influences of supply and demand as well as varying cost structures also are considered by the market. An individual trader may adjust the upper and lower prices in response to variables that go beyond normal market information.