Options Selling & Income Strategies - Advanced Income Generation

An option with intrinsic value is called in-the-money. An option with no intrinsic value is called out-of-themoney. A put option with a strike price below the underlying futures price (basically, the right to sell low) is out-of-themoney. A call option with a strike price above the underlying futures price (basically, the right to buy high) is also out-ofthe- money.

If the strike price and underlying futures price are equal, the option is called at-the-money. In addition to an option’s premium (or market value) being influenced by intrinsic value, an option also has the potential to establish or increase its intrinsic value before expiration takes place. This second factor influencing the premium is called time value.

An out-of-the-money option has no intrinsic value today, but the market price of the underlying futures contract changes over time. For example, assume you have a 75-cent December live cattle put. The current market price of December live cattle futures is 76.00 cents.

Since the current market price of the underlying futures contract (76.00 cents) is above the put option’s strike price (75.00 cents), the put is out-of-the-money. However, there is some chance that the price of the underlying futures contract (December live cattle) may decline over time. If the price of the underlying futures contract decreases to a level below 75.00 cents, the put option becomes in-the-money and has intrinsic value.

Thus, the probability that the price of the underlying futures contract will change by enough (more than 1.00 cent per pound in the above example) to put the option in-themoney determines time value. The same logic provides a time value to in-themoney options, since an appropriate change in the underlying futures price can increase intrinsic value.

Time value is difficult to measure precisely because the potential for a change in the underlying futures price is unknown. However, the amount of time until expiration, how far the option is out-of-the-money, and the price volatility of the underlying futures contract all influence time value.

Time value becomes smaller as:
1) the time to expiration decreases
2) the amount by which the option is out-of-the-money increases, or
3) price volatility of the underlying futures contract decreases.

Conversely, time value goes up as:
1) the time to expiration increases,
2) the amount by which the option is out-of-the-money decreases, or
3) price volatility increases.

If an option is in-the-money, the option holder has the right to acquire this value. The option holder can request and get the designated futures position at the strike price (exercise the option), and turn this futures position into a gain.

However, the marketplace recognizes the option’s value. This value is represented by the premium. Thus, the holder currently owns an option and can simply sell the option for the premium. Selling the option is usually easier, and the option holder also gets any time value reflected in the premium.

If the option remains out-of-the-money, the option holder does nothing and the option expires worthless on the expiration date. If an option expires worthless, the option holder loses the premium paid when the option was purchased.

Top