Intrinsic options are option strike prices that are “in the money”. Meaning if June gold is trading at $650, the June gold $640 call is in the money or intrinsic for $10. If the $640 call is trading at $14, $10 is the intrinsic value, and $4 is the premium. The $4 also is what the June $640 put is trading for. Using the same month and strike, the call, the put, and underlying futures price, has a definite relation to price. If any of the three is out of line, there would be an opportunity to arbitrage for a local floor trader to take advantage of and lock in a profit no matter where the market goes after. This is called reversals and conversions. The reason I mention this is to help you understand the relations between the three.
If you wanted to buy protection from unlimited losses on the futures contract you are planning to enter with the purchase of an option, which would be two trades, two commissions, two entries and two exits, when the same would be accomplished but better with the simple purchase of an intrinsic option. Example: buy a June gold futures contract at $650 and a June gold $640 put for $4. Instead buy a $640 call for $14 and in reality gaining the advantage as stated. An intrinsic option will act just like a futures contract minus the premium paid if you are right the market. If wrong it can only lose the amount paid for the option no matter how much the market moves against you. Like buying built in discipline to not let your losses run against you. The time decay of the premium inside the intrinsic option or the option held to protect the futures contract is the same at the same strike. The loss of this premium and intrinsic value is usually less than the futures stop loss and buys you the time for a turnaround without the worry of further loss. To me this is well worth it instead of trading a future with a stop. These options will act more like a futures contract with more profit as you are right, and act less like a futures contract and lose less money in relation to a futures contract if the market goes against you.
There are many trade offs using options and all must be considered to determine what the best strategy to use for each trade idea. The positive on this strategy is that the option acts more like a futures contract and manages time effectively. It allows you TIME to see if your trade idea is going to work or not with a KNOWN risk. The futures could stop you out. The trade off is the premium paid on the option over the intrinsic value, and to me well worth the premium in most cases. Also you must consider the market because of a possible liquidity problem.
Howard Tyllas Copyrighted June 10, 2007
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