If you are bearish on pork bellies, you can profit from a fall in pork bellies price by buying (going long) pork bellies put options.
You observed that the near-month CME Frozen Pork Bellies futures contract is trading at the price of USD 0.8470 per pound. A CME Pork Bellies put option with the same expiration month and a nearby strike price of USD 0.8500 is being priced at USD 0.0600/lb. Since each underlying CME Frozen Pork Bellies futures contract represents 40,000 pounds of pork bellies, the premium you need to pay to own the put option is USD 2,400.
Assuming that by option expiration day, the price of the underlying pork bellies futures has fallen by 15% and is now trading at USD 0.7200 per pound. At this price, your put option is now in the money.
By exercising your put option now, you get to assume a short position in the underlying pork bellies futures at the strike price of USD 0.8500. In other words, it also means that you get to sell 40,000 pounds of pork bellies at USD 0.8500/lb on delivery day.
To take profit, you enter an offsetting long futures position in one contract of the underlying pork bellies futures at the market price of USD 0.7200 per pound, resulting in a gain of USD 0.1300/lb. Since each CME Frozen Pork Bellies put option covers 40,000 pounds of pork bellies, gain from the long put position is USD 5,200. Deducting the initial premium of USD 2,400 you paid to purchase the put option, your net profit from the long put strategy will come to USD 2,800.
|Long Pork Bellies Put Option Strategy|
|Gain from Option Exercise||=||(Option Strike Price - Market Price of Underlying Futures) x Contract Size|
|=||(USD 0.8500/lb - USD 0.7200/lb) x 40000 lb|
|Investment||=||Initial Premium Paid|
|Net Profit||=||Gain from Option Exercise - Investment|
|=||USD 5,200 - USD 2,400|
|Return on Investment||=||117%|
In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.
In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the pork bellies option sale will be equal to it's intrinsic value.
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