futures options and backwardation/contango

panta_rhei · Post by **panta_rhei** » Wed May 14, 2008 1:20 pm

Hi!

As I understood Black's Model, basically S is just replaced by F. What I don't really get is: why is it that futures options on backwardated underlyings are "cheaper" than on underlyings in contango?

I mean obviously F is smaller S in backwardation, but S doesn't play any role anymore in Black's Model, does it?

Or is the reason that, if you buy the option atm, the strike equals the spot price (rather than the forward?) and hence the forward is otm and hence cheaper?

Any help is much appreciated!

Thanks and regards.

FDAXHunter · Post by **FDAXHunter** » Fri May 16, 2008 10:42 am

Yes, the option is ATM based on spot, but OTM based on the forward. Hence, cheaper.

CFloon · Post by **CFloon** » Fri May 16, 2008 10:19 pm

Yes, the option is ATM based on spot, but OTM based on the forward. Hence, cheaper.

Er, uh

????

FDAXHunter · Post by **FDAXHunter** » Sat May 17, 2008 8:50 am

Sorry, probably sounds confusing. The strike you pick (X), which might look like it's ATM if you look at spot, but the further along the forward curve you go, the lower the forward price, hence, the further OTM it gets with increasing maturity of the underlying futures contract.

In other words, your picking a series of options with a constant strike price X, but the forward distance to that strike price on (X-F1, X-F2, X-F3, etc) gets progressively larger.

Better CFloon?