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.