Trading Options
What are known as put and call options are traded on most active futures contracts. The principal attraction of buying options is that they make it possible to speculate on increasing or decreasing futures prices with a known and limited risk. The most that the buyer of an option can lose is the cost of purchasing the option (known as the option "premium") plus transaction costs.
Options can be most easily understood when call options and put options are considered separately, because they are totally separate and distinct. Buying or selling a call in no way involves a put, and buying or selling a put in no way involves a call.
Buying Call Options
The buyer of a call option acquires the right, but not the obligation, to purchase (go long) a particular futures contract at a specified price at any time during the life of the option. Each option specifies the futures contract which may be purchased (known as the "underlying" futures contract) and the price at which it can be purchased (known as the "exercise" or "strike" price).
A March Treasury bond 92 call option would convey the right to buy one March U.S. Treasury bond futures contract at a price of $92,000 at any time during the life of the option.
One reason for buying call options is to profit from an anticipated increase in the underlying futures price. A call option buyer will realize a net profit if, upon exercise, the underlying futures price is above the option exercise price by more than the premium paid for the option. Or a profit can be realized if, prior to expiration, the option rights can be sold for more than they cost.
Example: You expect lower interest rates to result in higher bond prices (interest rates and bond prices move inversely). To profit if you are right, you buy a June T-bond 90 call. Assume the premium you pay is $2,000.
If, at the expiration of the option (in May) the June T-bond futures price is 93, you can realize a gain of three (that's $3,000) by exercising or selling the option that was purchased at 90. Since you paid $2,000 for the option, your net profit is $1,000 less transaction costs.
As mentioned, the most that an option buyer can lose is the option premium plus transaction costs. Thus, in the preceding example, the most you could have lost-no matter how wrong you might have been about the direction and timing of interest rates and bond prices-would have been the $2,000 premium you paid for the option plus transaction costs. In contrast, if you had an outright long position in the underlying futures contract your potential loss would be unlimited.
It should be pointed out, however, that while an option buyer has a limited risk (the loss of the option premium), his profit potential is reduced by the amount of the premium. In the example, the option buyer realized a net profit of $1,000. For someone with an outright long position in the June T-bond futures contract, an increase in the futures price from 90 to 93 would have yielded a net profit of $3,000 less transaction costs.
Although an option buyer cannot lose more than the premium paid for the option, he can lose the entire amount of the premium. This will be the case if an option held until expiration is not worthwhile to exercise.
Buying Put Options
Whereas a call option conveys the right to purchase (go long) a particular futures contract at a specified price, a put option conveys the right to sell (go short) a particular futures contract at a specified price. Put options can be purchased to profit from an anticipated price decrease. As in the case of call options, the most that a put option buyer can lose, if he is wrong about the direction or timing of the price change, is the option premium plus transaction costs.
Example: Expecting a decline in the price of gold, you pay a premium of $1,000 to purchase an April 300 gold put option. The option gives you the right to sell a 100-ounce gold futures contract for $300 an ounce.
Assume that, at expiration, the April futures price has-as you expected-declined to $280 an ounce. The option giving you the right to sell at $300 can thus be sold or exercised at a gain of $20 an ounce. On 100-ounces, that's $2,000. After subtracting $1,000 paid for the option, your net profit comes to $1,000.
Had you been wrong about the direction or timing of a change in the gold futures price, the most you could have lost would have been the $1,000 premium paid for the option plus transaction costs. However, you could have lost the entire premium.
How Option Premiums are Determined
Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers.
Three major variables influence the premium for a given option:
- The option's exercise price, or more specifically, the relationship between the exercise price and the current price of the underlying futures contract. All else being equal, an option that is already worthwhile to exercise (known as an "in-the-money" option) commands a higher premium than an option that is not yet worthwhile to exercise (an "out-of-the-money" option). For example, if a gold contract is currently selling at $290 an ounce, a put option conveying the right to sell gold at $310 an ounce is more valuable than a put option that conveys the right to sell gold at only $280 an ounce.
- The length of time remaining until expiration. All else being equal, an option with a long period of time remaining until expiration commands a higher premium than an option with a short period of time remaining until expiration because it has more time in which to become profitable. Said another way, an option is an eroding asset; its time value declines as it approaches expiration.
- The volatility of the underlying futures contract. All else being equal, the greater the volatility the higher the option premium. In a volatile market, the option stands a greater chance of becoming profitable.
Selling Options
At this point, you might well ask, who sells the options that option buyers purchase? The answer is that options are sold by other market participants known as option writers, or grantors. Their sole reason for writing options is to earn the premium paid by the option buyer. If the option expires without being exercised (which is what the option writer hopes will happen), the writer retains the full amount of the premium.
It should be emphasized and clearly recognized, however, that unlike an option buyer who has a limited risk (the loss of the option premium), the writer of an option has unlimited risk. His loss, except to the extent offset by the premium received when the option was written, will be whatever amount the option is "in-the-money" at the time of expiration. Simply said, any profit realized by an option buyer represents a loss for the option seller. And, it's worth saying again, there is no limit on how large this loss can be!
The foregoing is, at most, a brief and incomplete discussion of a complex topic. Options trading has its own vocabulary and its own arithmetic. If you wish to consider trading in options on futures contracts, you should discuss the possibility with your broker and read and thoroughly understand the risk disclosure statement which he is required to provide. In addition, have your broker provide you with educational and other literature prepared by the exchanges on which options are traded.
Options Strategies
Bullish Strategy
Bull Spread - Long a call with a nearby strike and short a call with a further out strike.
When to use: If you think the market trend is up. Good position if you want to be in the market but are unsure of bullish expectations.
Risk Potential: The premium paid for the spread.
Profit Potential: The difference between the strikes minus the cost of the spread at expiration.
Example: Bought the Mar 450 Silver call at 15 and sold the Mar 550 Silver call at 5. The cost is 10 cents or $500.00. The potential is the difference between the strikes, which is $1.00. The minimum tic value in Silver is $50.00. Total Profit Potential is $5000.00 minus $500.00, which is $4,500.00.
Synthetic Long Futures - Long a call and short a put.
When to use: When you are bullish on the market and uncertain about volatility. It's the same risk as a long futures position except that there is a flat area of little or no gain or loss, which is usually the effect of time decay.
Risk Potential: Loss increases as the market falls past the short put. Loss at expiration is open-ended and is based on the exercise price of the short put plus or minus the price received or paid to initiate the position.
Profit Potential: Profit at expiration is the exercise price of the call plus or minus price received or paid to initiate the position.
Example: Bought the Dec 290 Gold call at 400 and sold the Dec 260 Gold put at 380. The Potential is the difference between the strike price of the call and where the underlying futures is trading at expiration minus price paid or plus price collected for the spread.
Long Straddle - Long a call and long a put of the same strike in the same market.
When to use: If a market it is in a tight channel and you expect it to start moving but are unsure of which way. Especially good position if the market has been quiet, then starts to zigzag sharply, signaling potential eruption.
Risk Potential: Limited to the cost of the spread.
Profit Potential: Profit is open-ended in either direction. At expiration, the difference between either the put or the call and the underlying futures contract minus the cost of the spread. However this position is seldom held until expiration because of increasing decay levels with time.
Example: Long the Dec 9625 Euro-dollar call at 15 and long the Dec 9625 Euro-dollar put at 19. The Dec Euro-dollar future is trading at 9621. Profit potential is for a break to either side of the futures market, which could be unlimited. Risk is the combined premium of 33.5 points or $837.50.
Bearish Strategy
Bear Spread - Long a put with a nearby strike and short a put with a further out strike.
When to use: If you think the market trend is down. The most popular position among bears because it may be entered as a conservative trade when uncertain about a bearish stance.
Risk Potential: The premium paid for the spread.
Profit Potential: The difference between the strikes minus the cost of the spread at expiration.
Example: Bought the Dec 1000 S&P put at 980 and sold the Dec 950 S&P put a 630. The cost is 350 points or $875.00. The potential is the difference between the strikes, which is 5000 points. The minimum tic value in the S&P is $250.00. Total Profit Potential is $12,500.00 minus $875.00, which is $11,625.00.
Synthetic Short Futures - Long a put and short a call.
When to use: When you are bearish on a market but uncertain about volatility. Its risk/reward is the same as short futures except that there is a flat area of little or no gain/loss, which is usually the effect of time decay.
Risk Potential: Loss increases as market rises past the short call. Loss at expiration is exercise price of the short call plus or minus the price received or paid to initiate position.
Profit Potential: Profit increases as market falls past the long put. Profit at expiration is exercise price of long put plus or minus the price received or paid to initiate the position.
Example: Buy the Sept 102 Bond put at 35 and sell the Sept 106 Bond call at 31. The Potential is the difference between the strike price of the put and where the underlying futures is trading at expiration minus price paid or plus price collected for the spread.
Short Strangle - Short a call and short a put.
When to use: When a market has tremendous volatility and appears to be quieting down. If a market goes into stagnation it becomes more profitable.
Risk Potential: At expiration, losses occur if the market is above the call strike or below the put strike. It can be open-ended and stops are recommended for risk management.
Profit Potential: At expiration, the underlying futures contract remains between the call and put and the premium collected is the profit.
Example: Short a Sept 100 Bond put at 13 and short a Sept 106 Bond call at 18. Potential profit is 31 tics or $484.37. Maximum risk is unlimited.
Trading Terminology Glossary
Call Option - The buyer of a call option acquires the right but not the obligation to purchase a particular futures contract at a stated price on or before a particular date.
Commission - A fee charged by a broker to a customer for performance of a specific duty, such as the buying or selling of futures contracts.
Futures Contract - A legally binding agreement to buy or sell a commodity or financial instrument at a later date. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity.
Hedging - The practice of offsetting the price risk inherent in any cash market position by taking the opposite position in the futures market. Hedgers use the market to protect their businesses from adverse price changes.
Leverage - The ability to control large dollar amounts of a commodity with a comparatively small amount of capital.
Liquidity - (Liquid Market) A broadly traded market where buying and selling can be accomplished with small price changes and bid and offer price spreads are narrow.
Long - One who has bought futures contracts or owns a cash commodity.
Margin - An amount of money deposited by both buyers and sellers of futures contracts and by sellers of option contracts to ensure performance of the terms of the contract (the making or taking delivery of the commodity or the cancellation of the position by a subsequent offsetting trade). Margin in futures is not a down payment, as in securities, but rather a performance bond.
Offset - To take a second futures or options position opposite to the initial or opening position.
Option Contract - A contract which gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a commodity at a specific price within a specified period of time. The seller of the option has the obligation to sell the commodity or futures contract or buy it from the option buyer at the exercise price if the option is exercised.
Option Premium - The price a buyer pays for an option. Premiums are arrived at through open competition between buyers and sellers on the trading floor of the exchange.
Position Limit - The maximum number of speculative futures contracts one can hold as determined by the Commodity Futures Trading Commission and/or the exchange where the contract is traded.
Price Limit - The maximum advance or decline from the previous day's settlement price permitted for a futures contract in one trading session.
Put Option - An option that gives the option buyer the right but not the obligation to sell the underlying futures contract at a particular price on or before a particular date.
Short - One who has sold futures contracts or the cash commodity.
Speculator - One who tries to profit from buying and selling futures and options contracts by anticipating future price movements.
Spot - Usually refers to a cash market price for a physical commodity that is available for immediate delivery.
Spreading - The simultaneous buying and selling of two related markets in the expectation that a profit will be made when the position is offset.
Strike Price - The price at which the buyer of a call (put) option may choose to exercise his right to purchase (sell) the underlying futures contract.