long exercises, you become short one futures contract at 10,000. If you are
short one put and the long exercises, you become long one futures contract
at 10,000.
Buyers of options enjoy fixed risk. They can lose no more than the premium
they pay to go long an option. On the other hand, sellers of options have
potentially unlimited risk. Catastrophic moves in the markets often
bankrupt imprudent option sellers.
Option premiums
The purchase price of the option is called the option premium. The option
premium is quoted in points, each point being worth $100. The premium for
a Dow Index option is paid by the buyer at initiation of the transaction.
The underlying instrument for one CBOT® futures option is one CBOT®
DJIASM futures contract; so the option contract and the futures contract are
essentially different expressions of the same instrument, and both are based
on the Dow-Jones Index.
Options premiums consist of two elements: intrinsic value and time value.
The difference between the futures price and strike price is the intrinsic
value of the option. If the futures price is greater than the strike price of a
call, the call is said to be “in-the-money.” In fact, you can be long the
futures contract at less than its current price. For example, if the futures
price is 10,020 and the strike price is 10,000, the call is in-the-money and
immediate exercise of the call pays $10.00 times the difference between the
futures and strike price, or $10 x 20 = $200. If the futures price is less than
the strike price, the call is “out-of-the-money.” If the two are equal, the call
is “at-the-money.” A put is in-the-money if the futures price is less than the
strike price and out-of-the-money if the futures price is greater than the
strike price. It is at-the-money when these two prices are equal.
Since a Dow Index futures option can be exercised at any date until
expiration, and exercise results in a cash payment equal to the intrinsic
value, the value of the option must be at least as great as its intrinsic value.
The difference between the option price and the intrinsic value represents