Market Operations - Option Premiums
It is difficult to completely separate the futures markets from the options markets. Not only do futures and options share a pedigree, they trade on related exchanges and share a great deal of vocabulary. It is also important to note that options on futures contracts comprise an important component of these overlapping fields. To know how to value futures, one needs to know how to value options.
"Premium" is one of those words with different meanings in different contexts. In terms of option pricing, a premium is the price the buyer pays to an option writer for granting an option contract.
Although the option premium is set entirely by supply and demand forces in a public market, conceptually it is comprised of two elements: "intrinsic value," the option's value if immediately exercised and "time value," the option's potential to gain intrinsic value before it expires.
Time value, then, is the delta between what the option is worth today and what it was sold for. An option's time value equals the option premium minus the option's intrinsic value.
One reason this is important to players in the futures market is that there is often a gap between an option's strike price – its intrinsic value – and the futures price for the same underlying assets. That futures price is essentially a proxy for the option's time value.
The premium quote on a Chicago Mercantile Exchange (CME) Euro FX September 1.325 call option is quoted at .54 cents/euro. In other words, the buyer of this option has the right, but not the obligation, to go long CME Euro FX futures at 1.325 any time before expiration. The buyer of this call will pay $675.00 (.54 cents/euro x125,000 euro = $675.00) to the seller for this right.
Quotes for Treasury and municipal obligation contracts are slightly different. These interest rate options provide investors with an opportunity to take positions based upon their expectations of the direction of interest rates. A call buyer believes interest rates will go up, while a put buyer anticipates that rates will go down. Underlying securities have tenors ranging from 90 days to 30 years, so investors can place their bets with regards to the timing of their anticipated interest rate fluctuations.
Treasury obligation contracts are traded on the CME. Their premium quotes are stated in decimals, with one point equaling $100. The minimum tick for options trading below 3.00 ($300) is 0.05 ($5). For all other series, the minimum tick is 0.10 ($10). These contracts are "European-style," which means that they can be exercised only on the last business day before the expiration date. This is in contrast to "American-style" options, which can be exercised on any date before expiration. Most options traded in the United States that are not related to interest rates are American-style.
These options are also cash-settled, so there is no need to deliver Treasury instruments upon exercise.
When Treasury rates change, corresponding underlying values for the options on interest rates also change. For example, if the yield-to-maturity on the 30-year T-bond increases from 6.25 to 6.36%, the option quote would move from 62.50 to 63.60. For every one percentage point rise or fall in interest rates, underlying values would rise or fall 10 points.
T-bills have face values of $1 million and a time to maturity of 90 days; the clock starts at the expiration date of the futures contract. Price quotes for T-bill futures use the International Monetary Market (IMM) Index, which is computed by subtracting the discount yield from 100. Thus, if a T-bill has a discount yield of 7.45%, its IMM index value is 92.55.
IMM Index = 100.00 – discount yield
Quoting, however, is not pricing. The IMM index is simply a convention to ensure that ask prices are above bid prices in the interest rate markets, just like they are in all other markets.
There is more involved in computing the price of a T-bill future than subtracting out the discount yield. First, one must compute the price of the underlying T-bill.
T-bill price = $1,000,000 - discount yield x $1,000,000 x days to maturity 360
From Formula 4.2, we can work an example to compute the price of a T-bill with a 6.00% discount and 90 days to maturity. (Most T-bills dedicated to the futures market will have 90 days to maturity.) The numerator would come to $5,400,000 (.06 x $1,000,000 x 90). Divided by 360, that comes to $15,000. Subtracted from $1,000,000, that equals $985,000.
If the futures yield rose to 6.04%, we would re-do the calculation and come up with $984,900.
Tips & Tricks
For every basis point increase – that is, for every additional 100th of a percent discount yield – on a T-bill with 90 days to maturity, the T-bill's price declines by $25.
Knowing how to calculate the T-bill's price as of the expiration date allows you to determine the intrinsic value of the contract to deliver it.
T-bonds and T-notes have a somewhat different pricing structure that a futures trader would need to understand. While T-bills are traded on the CME, T-bonds and T-notes trade on the CBOT, which has different rules. Trading T-bond futures, in fact, is perhaps the highest-volume business the CBOT does. Of course, there are differences in the structure of the bond market versus the bill market on the East Coast before the futures even enter the pits in
As opposed to T-bills, which are quoted in easy-to-understand decimals, the longer-term T-bonds and T-notes are quoted in "points and 32nds of par." As complex as that sounds, it simply means that a quote of "98-24" translates as, "This bond is worth 98 and 24/32 percent of its $100,000 face value, or $98,750."
Tips & Tricks
The minimum tick for a T-bond is $31.25 (one thirty-second of one percent of $100,000).
There is a specific procedure for delivering T-bond futures:
- Two days before the delivery day, the parties taking the long and short positions each declare their positions and notify the clearinghouse of their willingness to take delivery and intention to make delivery.
- The next day, the "notice of intention day," the clearinghouse matches the long and the short and notifies them of each other's contact information. The short invoices the long.
- The next day, "delivery day," the short acquires the bonds and delivers them to the long, who makes payment to the short. Title passes and the long assumes ownership of the bonds.
Interest rates for U.S.-domiciled municipal bonds tend to follow those of the federal government's Treasury obligation. Still, the market for muni futures is unique in a number of respects.
The muni futures contract is actually index-based, rather than tracking an underlying asset. Specifically, it is based on The Bond Buyer Municipal Bond Index (MBI), which tracks 40 investment-grade, tax-exempt bonds that pay a fixed-rate semi-annual coupon.
The math required to compute the MBI is more complex than a newly-minted, Series 3 futures trader is expected to master. Suffice to say, though, that muni futures are quoted in points-and-32nds-of-par, with par defined as 1,000 times the MBI. The tick size is $31.25. On the final trading day, the futures settlement price is equal to the cash value of the index to ensure convergence of the futures and cash market prices.
Investing BasicsPlain vanilla is a term used in investing to describe the most basic types of financial instruments.
InvestingCommodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
InvestingWest Texas Intermediate oil futures have recently made pronounced movements. What do they bode for the world market?
InvestingGrowing global demand for quinoa has impacted Bolivian farmers' way of life. Should the American consumer be wary of buying this product?
EconomicsThe Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
Investing NewsAlcoa plans to split into two companies. Is this a bullish catalyst for investors?
InvestingIn an industry still largely predominated by men, we look at 6 leading female value investors working today.
Forex FundamentalsThe best times to trade the Mexican peso are centered around economic releases, typically in the morning hours.
Chart AdvisorNews out of Alcoa is causing active traders to turn toward base metals for opportunities. Before diving into the market, check out the charts of these three ETFs.
Stock AnalysisRead about some of the holdings in Carl Icahn's portfolio. Learn about his activist campaigns against companies that he believes are performing poorly.
The estimated volatility of a security's price.
The most basic or standard version of a financial instrument, ...
A security with a price that is dependent upon or derived from ...
A securities license entitling the holder to register as a limited ...
A transaction that can cancel out a forward contract that has ...
The security that is delivered by the short position holder in ...
Financial advisors are not required to have university degrees. However, they are required to pass certain exams administered ... Read Full Answer >>
Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>
Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>