Call price curves on the July grains and wheat futures charts are formed by actual market prices, and those market prices fall close to a theoretically correct curve based on fundamental option pricing variables: Time to expiration, volatility of the underlying futures contract and the current futures price relative to the strike price.
An alternative method for constructing an options price curve is the LLP model available as an Excel spreadsheet that can be downloaded from our Tools & Resources page. The model uses market prices to compute a regression curve. Deviations of market prices from the regression curve generally are small in terms of option price points.
“Calls on July oats” (below) shows the accuracy with which the regression analysis matches the option market prices. The blue squares represent market prices for 14 strike prices and the black dots in the blue targets are prices predicted by regression analysis.
When variations in options points are multiplied by the number of dollars per point, the results indicate over- or under-pricing by the market for each strike price. Because options prices tend to regress toward the predicted or theoretical price curve, trading opportunities may occur.
Even when the predicted prices seem to be right on target, there may be substantial variations in terms of dollars. This was pointed out in “Building forex volatility strategies,” in which some currency option points are worth $100,000 or $125,000 while variations from the predicted curve are microscopic. For grain options, each option point is valued at only $50, but variations frequently are large enough to suggest trading situations.