The Basics - Options on Futures
Options on futures contracts have added a new dimension to futures trading. Like futures, options provide price protection against adverse price moves. Present-day options trading on the floor of an exchange began in April 1973 when the Chicago Board of Trade created the Chicago Board Options Exchange (CBOE) for the sole purpose of trading options on a limited number of New York Stock Exchange-listed equities. Options on futures contracts were introduced at the CBOT in October 1982 when the exchange began trading Options on U.S. Treasury Bond futures.
1. What is an option anyway?
An option is a derivative. That is, its value is derived from something else. In the case of a futures option, its value is based on the underlying futures contract.
2. Puts and Calls
Options come in two primary forms. They are calls and puts. One call option gives the holder the right, not the obligation, to buy one futures contract at a fixed price and for a fixed period of time. A put option gives the holder the right, not the obligation, to sell one futures contract for a fixed price and for a fixed period of time. This is why an option is considered to be a ‘wasting’ asset. Since the option only has value for a fixed period of time, its value decreases, or ‘wastes’ away with the passage of time.
Many of you can relate this to real estate. Let’s say you found a house that was priced under the fair market value. The area this house is in is appreciating very nicely and will be worth more three months down the road. You did your homework and know that you could sell the house for more than the asking price later, but you cannot afford to buy the house.
You could ask the seller for an option that guarantees you right, but does not obligate you to purchase this house three months later. Your goal would be to sell the house at a later date for more than the seller is willing to sell it for now.
If the seller is asking $100,000 for his house, and the house is worth $125,000 you could ask the seller to write you an option that will guarantee you the right to purchase this house for $100,000 three months later. And you could offer the seller $5,000 for this option. If he accepts the offer, you have control over this house for three months. Then, you go out and find a buyer for the house at a selling price of $125,000. If you can do this before your option expires you can purchase the house for $100,000 and sell it for $125,000. You just made $25,000 - $5,000 for the cost of the option.
If you can’t find a buyer for the house within three months, your option will expire worthless and the homeowner gets to keep the $5,000 premium.
3. The Four Components to an Option
There are four components to an option. They are the underlying futures contract, the type of option (put or call), the strike price, and the expiration date. Let’s take a XYZ November 100 call option as an example. XYZ is the underlying futures contract. November is the expiration month. 100 is the strike price. And the option is a call (the holder has the right, not the obligation, to buy 1 futures contract of XYZ at a price of 100).
4. The Parties to an Option
There are two parties to an option. There is the party who buys the option; and there is the party who sells the option. The party who sells the option is the writer. The party who writes the option has the obligation to fulfill the terms of the contract should it be exercised. The buyer has the right but not the obligation to exercise the option, or sell the option anytime up until the expiration date.
5. At-The-Money, In-The-Money, Out-Of-The-Money
There are three different terms for describing where an option is trading in relation to the price of the underlying futures contract. These terms are ‘at-the-money’, ‘in-the-money’, and ‘out-of-the money’. Let’s use our XYZ November 100 call as an example. If XYZ futures are trading at a price of 100, the November 100 call is considered to be trading ‘at-the-money’. If XYZ futures are trading at a price greater than 100, say 102, the call option is considered to be ‘in-the-money’. And if XYZ is trading at a price less than 100, say 98, the call option is considered to be trading ‘out-of-the- money. Conversely, if it was an XYZ November 100 put option we owned, if the price of XYZ futures was 102, the put option would be considered to be ‘out-of-the-money. And if XYZ futures were trading at a price of 98, the put option would be considered to be trading ‘in-the-money’. If XYZ futures were again trading at 100, the put option would be ‘at-the-money’.
6. Intrinsic Value & Time Value
Intrinsic Value
The price difference between the underlying futures contract and the option’s strike price is the intrinsic value. For example, let’s take that XYZ November
100 call. If XYZ is trading at 102, and the call option is priced at 2, the intrinsic value is 2. If an XYZ November 100 put is trading at 3, and the price of XYZ futures is trading at 97, the intrinsic value of the put option is 3. If XYZ futures were trading at 99, an XYZ November 100 call would have no intrinsic value. And conversely, if XYZ futures were trading at 101, an XYZ November 100 put option would have no intrinsic value. An option must be in-the-money to have intrinsic value.
Time Value
Time value is the amount by which the price of the option exceeds its intrinsic value. For example, that XYZ November 100 call, with XYZ trading at 102, might be selling for 4-1/2. Thus, there is 2 points in intrinsic value and 2-1/2 points in time value. If XYZ were trading at 99, and the price of the option was 2, there would be no intrinsic value and 2 points in time value. If an XYZ
November 100 put was priced at 3 and XYZ futures was trading at 99, there would be 1 point in intrinsic value and 2 points in time value. If an XYZ November 100 put was trading at 2 and XYZ futures was priced at 101, there would be 2 points in time value and no intrinsic value. The time value premium of an option declines as the expiration date approaches.
Intrinsic Value + Time Value = Option Price
Factors Influencing the Price of an Option
There are four major factors that determine the price of an option. They are:
The price of the underlying futures contract
The strike price of the option itself
The time remaining until the option expires
The volatility of the underlying futures contractThe primary influence on an options price is the price of the underlying futures contract. On expiration day, if I own one XYZ November 100 call, and XYZ is trading at 95, my call is worthless. On the other hand, if I own one XYZ
November 100 call, and the price of XYZ on expiration day is 102, my call is worth at least 2 points.
An options price decays each day it is in existence. Further, the closer the option gets to expiration, the faster it decays. The rate of decay is related to the square root of the time remaining. An option with two months remaining decays at twice the speed of a four month option etc.
7. Volatility
The volatility part of the pricing model is a measure of the range the underlying futures contract is expected to fluctuate over a given period of time. The measurement of volatility is the standard deviation of the daily price changes in the futures contract. The more volatile the underlying futures are the greater the price of the option will be.
There are two different kinds of volatility. There is historical volatility; and there is implied volatility. Historical volatility estimates volatility based on past prices. Implied volatility starts with the option price as a given and works backward to ascertain the theoretical value of volatility equal to the market price minus any intrinsic value.
Implied volatility is the main weapon of the option trader. I will give a full explanation along with how it is to be used to gain a trading edge over the markets. For now just become associated with the term.
8. BUYING A CALL OPTION
A call is an options contract that gives a trader the right, not the obligation, to purchase the underlying futures contract at a specific price within a specific time period. Theoretically, the profit potential is unlimited, while the risk is limited to the amount paid for the option.
A trader might purchase the call instead of the underlying futures contract so that he is able to buy the underlying futures contract at a reasonable price without taking the chance that he misses out on a market move. He might want to do this if he had a large amount of cash coming in the near future, and had a smaller amount of cash available now. Feeling that a market move up is about to occur and he doesn’t want to miss out he would leverage his money now and buy the call.
A second type of trader may purchase call options as pure speculation. He may not have enough margin in his account to purchase 1 futures contract of XYZ. However, he has enough cash to purchase 1 XYZ November 95 call at 3-1/2. Assume XYZ is trading at 95 when he does this. Should the price of XYZ rise to 98, the 95 call might be worth about 5-1/2. The speculative trader would then have a profit. He leveraged his position greatly.
Purchasing an out of the money call option carries greater reward, however, it also carries greater risk. Assume a futures contract is presently trading at 36. A trader is choosing between buying the October 35 call at 2- 3/4 or the October 40 call at ½. For the October 40 call to get in the money, the underlying futures contract would have to move about 11-1/2% in a short period of time (presently two weeks). This is unlikely to happen.
However, if the trader purchases the October 35 call options the option has a much higher degree of probability of retaining value or increasing in price (assuming the underlying futures contract rises) than the lower priced option. If the trader can’t afford to buy the slightly in the money call option, he shouldn’t be speculating with this type of an investment or options strategy.
A trader should always be willing to cut his losses if the futures contract is performing badly. Avoid the tendency to hold on to an option in the hope that the underlying futures contract will come back in price. The probabilities indicate that the trader will do much better over time if he takes the small losses rather than holding out. The highly leverages positions in options strategies cut both ways.
If the underlying futures contract has advanced in price in the early stages of the call purchase, the trader has several choices. He can sell the call and liquidate the position. He can sell the call and use part of the proceeds to purchase the next higher strike call option. He can create a spread by selling the next higher strike against the lower strike that he presently owns.
He can do nothing and continue to own the call he has.
Liquidating the position and taking the profits is the least aggressive strategy. Keep in mind that if the underlying futures contract continues to rise in price, the trader loses out on this appreciation. Conversely, if the underlying futures contract declines in price, this would turn out to be the best choice.
Holding the call until expiration carries a great amount of risk. This is because the underlying futures contract could decline in price by expiration. Thus, the trader might be letting a profit turn into a loss. One of the things that should be avoided at all costs. It occasionally happens with different options strategies. However, it should be a rare exception.
The other two alternatives reduce risk; yet allow the trader to participate in the market and attempt to gain further profit. Selling (liquidating) the present call and rolling up to the next higher strike with part of the proceeds allows the trader the opportunity to continue in a position with little or no cost. He has kept most or all of his profits. Thus, he is playing with someone else’s money. Not a bad position to be in. The important thing to know is that there is an alternative options strategy available should the underlying decline in price.
9. BUYING A PUT OPTION
A put is an options contract that grants the owner of the put the right, not the obligation, to sell the underlying futures contract at a specific price, within a specific time frame. The owner of a put (long the put) is expecting the underlying futures contract to decline in price. Like a call option, the put option buyer has unlimited profit potential
Assume a trader expects the price of XYZ to decline from its current price of 93. He might buy the November 95 put option for 4-1/4. Should the price of XYZ decline to 88 by November expiration, the put option would be worth 7 points. A gain of 2-3/4 points or 69%. The trader might also choose to close the position if XYZ drops two or three points quickly. This is because there would still be a significant amount of time premium left (assume 3 or 4 weeks left to expiration). If this is the case, the trader would profit almost dollar for dollar with the decrease in price. Thus, he would realize even larger gains. Should the price of XYZ rise instead of decline, the most the trader can lose is his original investment of 4-1/4 points (plus commissions).
The risk is predetermined and set at the time he initiates his options position
Buying an out of the money put option carries a greater return. However, it carries greater risk. As is the case with a call, a buyer of an out of the money put option can find he picked the direction right, however, the underlying didn’t move down fast enough, leaving him with a loss. With a few exceptions, it is too risky for me to buy an out of the money put option or call option.
If a put option buyer finds himself with a substantial profit on the put, he can take several different courses of follow up action involving different options strategies. He can sell the put option (liquidate his position) and take the profit. He can do nothing and remain in the position. He can sell (liquidate) the put option, take the profit, and roll down into another put with part of the profit. Thus, holding a put option with someone else’s money (FREE TRADE).
A trader with a five point profit in a put option he’s holding may decide to sell (liquidate) the put option. He takes his profit and is on his way. However, this prevents the put holder from participating in any further gain because of further decline in the underlying futures contract.
The trader can do nothing and hold the put option until expiration if he is up several points on the put. However, this is a risky tactic. While he may profit further if the underlying goes down in price, he may also give substantial amounts of profit back if it rises in price.
Another options strategy alternative to the trader with a substantial profit in a put option is to sell the put and buy another lower strike put option. Assume a trader has purchased the XYZ November 95 put when XYZ was at 96 at a price of 1-1/2. A couple of weeks later, with one month until expiration, XYZ has fallen in price to 91; and the November 95 put option is now worth 6-1/2 points.
The trader could sell the November 95 put option for 6-1/2 and buy the November 90 put which is presently at 2-1/2. He has now kept 4 points of profit and is participating in the November 90 puts with someone else’s money (FREE TRADE). Further, he can participate in any further downside movement by XYZ.
Options should be used instead of futures contracts whenever the trader can realize a trading advantage. They are advantageous whenever they offer a higher mathematical probability of profit; less risk of sudden, unpredictable, adverse market moves (particularly for spreads); lower margin requirements; a better risk/reward ratio; and/or increased trading opportunities.
Disclaimer - I am not a commodity trading advisor. The information on this site is for trading education only. There are no trading recommendations for any one individual made on this site and this information is paper trades for trading education. All trades are extemely risky and only risk capital should be used when trading.
U.S. Government Required Disclaimer - Commodity Futures Trading Commission Futures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site. The past performance of any trading system or methodology is not necessarily indicative of future results.
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