The KCBT wheat option valuation
is not as straightforward as futures valuation. Option premium is comprised of intrinsic value and extrinsic value.
An option has intrinsic value if the market is trading above the strike price
of a call option, or below the strike price of a put option. If a option contract has intrinsic value it is called “in
the money.” If a option contact does not have intrinsic value it is called “out of the money.”
wheat is trading at $6.50 a $6.20 call option is $.30 in the money so the intrinsic value of the option is $1,500.
The extrinsic value of the option is its “time value.” Extrinsic
value takes into account the possibility that an option may go in the money by expiration. The more time that a option has
the more extrinsic value it has. As a option approaches it expiration date is looses value. This is called time decay. At
expiration a option has no extrinsic value so if the option is out of the money it expires worthless.
Wheat option prices do not move in tandem with futures prices. A $.01 move in your favor in the wheat
futures markets does not necessarily equal to a $.01 increase in the wheat option value. The amount that a option value will
increase based upon a increase in its futures price is called its delta. Call option deltas are measures from 0 to 1. As a
option goes from “out of the money” to “in the money” its delta increases.
If a wheat
call option has a delta of .5 and the price of the wheat futures market increases by $.01 the value of the option will increase
by $.005 or $25.
An option buyer does not necessarily need
to exercise an option to realize a profit. Instead, the buyer may choose to liquidate his position by offsetting, or selling,
the option on or before the last trading day. A seller can offset by buying the option back.
If the option's value has increased,
the buyer who offsets will realize a profit. If the option's value has decreased, the buyer who offsets may be able to recover
some of the original premium paid, reducing his loss.
ability to buy and sell the option without becoming involved in the futures market enhances the option's flexibility as a