It is essential to understand option expiration, exercising, and assignment as a commodity option trader. Know these principles, whether purchasing outright calls or puts, selling or “writing” option contracts, or using complex option spread strategies. Not only will you be better equipped for such events, but also having this acumen could potentially improve your trading performance.
Commodity option contracts are derivatives, deriving their price from another asset class. An option contract derives its price from the underlying futures contract. Like futures contracts, option contracts have expiration dates set by the exchanges. The expiration date of a futures contract is the last trading day before physical delivery or cash settlement. The expiration date of an option contract is the last trading day or last day to exercise an option. Exchange rules differ per contract about the time an option contract will cease trading on expiration day. It may either be the underlying futures contract open outcry pit close or electronic exchange close. Option contracts will expire before the expiration date of the underlying futures contracts for purposes of exercising and assignment. There is correlation between time value (premium in relation to days until expiration) and intrinsic value (premium in relation to the strike price’s distance from underlying futures contract price) to the contract expiration date. As an option contract draws near its expiration date, both time value and intrinsic value are decreasing. Unless it is an in-the-money strike price, that intrinsic value is a one-to-one ratio of the strike price in relation to the underlying futures contract. For example, a long March 2013 Crude Oil 98.00 call will be valued at 1.00 points (or $1,000) if futures are at 99.00 on option expiration (February 14, 2013). On the other hand, if futures are at 97.99 or below on expiration the option contract is valued at zero.
Exercising of a long option contract can take place any time during trading hours before the option contract expires. Long (purchased) commodity option contracts (calls or puts) have the right to exercise the option. Commodity option trading follows American Style rules as opposed to European Style rules, in which options may only be exercised on the expiration date itself. Simply notify your broker of your intention, after confirmation, the option contract(s) is transferred into a futures position(s). A long call option will become a long futures position from the strike price. A long put option will become a short futures position from the strike price. The initial margin requirement for the underlying futures contract must be available in the trading account. Keep in mind the premium paid is forfeited, as well as any potential gains there may have been in the options market. After the close on the last trading day, all in-the-money options will be automatically exercised, unless notice to cancel automatic exercise is given to the clearinghouse. There should be notification of option exercising before the open outcry session commences trading the following day of the underlying futures contract.
Assignment of a short option contract can also take place anytime during trading hours before the option contract expires. The “writer” (seller) of a commodity option contract (call or put) is obligated to the underlying futures contract. The clearinghouse will assign contracts randomly. Remember, commodity option trading is a zero sum game, for each buyer there must be a seller. A short call option will be assigned a short futures position at the strike price. A short put option will be assigned a long futures position at the strike price. Note assignment of a futures contract is possible even if your short option is out-of-the-money. There should be notification of the assignment before the open outcry session commences trading the following day of the underlying futures contract. The initial margin requirement for the underlying futures contract must be available to hold the position in the trading account. Otherwise, the futures position must be liquidated or funds added to the trading account to cover the initial margin deficit. An assigned short option contract collects the full premium. Therefore, the break-even price becomes the premium minus the intrinsic value. For example, a short March 2013 Crude Oil 98.00 call option, sold for 50 points, will be at break-even (not including commission and fees) if futures are at 98.50 on option expiration (February 14,2013).
To continue your commodity option trading education I invite to view my video on Contract Logistics.