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What is time value of an option?

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Part eight in a series: The prospect of margin calls is why most traders are willing to pay so much for options.

Editor’s note: This eighth essay discussing how to use options to enhance your grain marketing was written after the close Monday, April 25, 2022. 

For the second day in a row, September CBOT wheat settled 2 cents lower today, at $10.71¼.  Also, for the second day in a row, the September $10 and $9 puts lost value. The $10 put lost 5 cents and the $9 put lost 1 3/8 cents.  

As you should already know, puts are supposed to increase in value when the futures price goes down. So what is going on?

The puts are losing time value. Every day, options lose one day of life. Therefore, the probability of that option making money also diminishes. When the futures move only 2 cents on a given day, the time value becomes the market mover for options.

On April 18, September wheat settled at $11.23¼. The $10 put settled at 50 cents even.   

If a person exercised (exchanged the option for a futures contract) a $10 put, it would become a short (sold) futures position at $10. With futures at $11.23¼, that short futures position at $10 would have a loss of $1.23¼.

Why would anyone pay 50 cents for the right to sell September wheat at $10 if September wheat is at $11.23¼?   

Margin calls! 

If a person sells futures and the price goes up, the futures loss has to be matched penny for penny every day.

If a person buys a put option and the futures goes up, no margin calls.

It is really that simple. The prospect of margin calls is why most traders are willing to pay so much for options.

With September wheat futures price at $11.23¼ on April 18, the futures must decline $1.23¼ to be even with the strike price. That $10 put option was $1.23¼ out-of-the-money on the 18th.

With yesterday’s settlement at $10.71¼, the $10 put was 71¼ cents out-of-the-money.

In both situations, the premium value of the option was determined by the market’s assessment of the probability that September wheat will be below $10 on Aug. 26, 2022.

When an option is out-of-the-money, 100% of the premium is time value.  

Think about this: Was the September $11 put out-of-the-money on the close today?

September futures settled at $10.71¼. The answer is between your ears.

Who wants to be short (sold) September wheat at $11.00 with the market at $10.71¼?

Or would you rather be short (sold) at $10 with the market $10.73¼? If you do not immediately know the answer to those two questions, it is because you do not understand how the futures market works. Learn how the futures market works before you try to understand options on futures contracts.

The chart is the closing numbers for September 2022 CBOT wheat April 25, 2022:

20 April 2022 Sept Wheat Put $

This is part eight in a series. To learn more, read: 

Part one: Put options add value to your cash grain sales

Part two: Hedge your crops with no margin calls

Part three: Enhance profit opportunities with put options

Part four: Put options and no margin calls

Part five: When does a put option have no potential value?

Part six: Why are put options so expensive?

Part seven: Use puts to manage grain marketing risk

Part nine: How to calculate time value of an option

Part ten: Use puts with Hedge-to-Arrive to increase farm income

Part eleven: Sample timeline to explain how wheat puts work

Wright is an Ohio-based grain marketing consultant. Contact him at (937) 605-1061 or rjw1249@wrightonthemarket.com. Read more insights at www.wrightonthemarket.com.

No one associated with Wright on the Market is a cash grain broker nor a futures market broker. All information presented is researched and believed to be true and correct, but nothing is 100% in this business.

The opinions of the author are not necessarily those of Farm Futures or Farm Progress. 

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