# How do Commodity Options Work?

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How is the value of an option determined?

You must first understand the meaning of the terms intrinsic and extrinsic. The option premium is made up of these two values. Intrinsic is the value of the option if you have exercised it on the futures contract and then cleared. For example, if you have a soybean call from November 5th and the futures price for this contract is \$ 5.20, then there is an intrinsic value of 0.20 for this option. Soybeans is a 5,000 bushel contract, so 20 cents multiplied by 5,000 = \$ 1,000 intrinsic value for this option.

Now, let's say the same November 5 soybean call costs \$ 1,600 as a bonus. \$ 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 to expire, it has more time value than it would with 45 days remaining. If the market has large price movements from low to high, the volatility premium will be higher than a market with low price movement. If many people buy this exact strike price, that demand can also artificially increase the premium.

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

You can figure it out by finding out the delta factor of your option. The delta factor tells you how much of the premium variation will occur in your option depending on the movement of the underlying future contract. Let's say you think gold in December will rise by \$ 50 / ounce or \$ 5,000 / contract upon expiration. You bought an option with a delta factor of 0.20 or 20%. This option is expected to earn around \$ 1,000 as a bonus over the expected \$ 5,000 gold futures price movement.

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

Yes, as long as the option premium increases enough to cover your transaction costs such as commission and fees. For example, you have a \$ 3 corn call in December and December corn is \$ 270 / bushel and your transaction costs were \$ 50. Let's say your option has a 20% delta and the future December corn market goes up 10 cents / bushel to \$ 2.80 / bushel. Corn is a contact of 5000 bushels so 1 cent multiplied by 5000 = \$ 50. Your option premium will increase by approximately 2 cents = \$ 100. Your breakeven point was \$ 50 so you have a \$ 50 profit with no intrinsic value because you are always 20 cents out of cash.

Investing in futures and options is very risky and only venture capital should be used. Past performance does not represent future results. Cash, options and futures do not necessarily respond to similar stimuli in the same way. There are no guaranteed good trades.