How do commodity options work?

How is the value of an option calculated?

First you have to understand the meaning of intrinsic and extrinsic. The premium option is made up of these two values. Intrinsic is the value of the option if you exercised it in the futures contract and later offset it. For example, if you have a $5 November call on soybeans and the futures price for that contract is $5.20, then there is an intrinsic value of 0.20 for that option. Soybeans is a 5,000 bushel contract, so 20 cents multiplied by 5,000 = $1,000 intrinsic value for that option.

Now let’s say the same November $5 soybean call costs $1600 in premium. $1,000 of the cost is intrinsic value and the other $600 is extrinsic. The extrinsic value is made up of the time value, the volatility premium, and the demand for that specific option. If the option has 60 days left to expiration, it has more time value than if it had 45 days left. If the market has large price movements from low to high, the volatility premium will be higher than a market with a small price movement. If a lot of people are buying that exact strike price, that demand can also artificially increase the premium.

How much will the premium of an option move relative to the underlying futures contract?

You can find this out by finding out the delta factor of your option. The delta factor tells you how much the premium on your option will change based on the movement of the underlying futures contract. Let’s say you think December gold will go up $50/ounce or $5000/contract at expiration. You bought an option with a delta factor of .20 or 20%. This option should earn approximately $1,000 in premium value from the $5,000 expected future gold price movement.

Can an option speculator make a profit before the option has intrinsic value?

Yes, as long as the option premium increases enough to cover transaction costs such as commissions and fees. For example, you have a $3 December corn call and December corn is $270/bushel and your transaction costs were $50. Let’s say your option has a 20% delta and the December corn futures market rises 10 cents/bushel to $2.80/bushel. Corn is a contact of 5,000 bushels, so 1 cent times 5,000 = $50. Your option premium will increase by approximately 2 cents = $100. Your breakeven point was $50, so you have a profit of $50 with no intrinsic value because you are still out of the money by 20 cents.

Investing in futures and options is very risky and only risk capital should be used. Past performance is not indicative of future results. Cash, options, and futures do not necessarily respond in a similar way to similar stimuli. There are no guaranteed good trades.