One of the best all-purpose investment rules anyone can follow is this: Never invest your money unless your understanding of the risks is as good as your understanding of the opportunities. Options on futures contracts are a relative new and increasingly popular type of investments. They have been competitively traded on regulated futures exchanges only since the early 1980′s. Yet they now account for a significant portion of the total volume of futures trading.
The principal attraction of options-known as call options and put options- is that they offer an option buyer the potential for substantial profit while limiting the options buyer’s risk to the up front cost of the options (known as the “premium”) plus commissions and other transaction costs. Despite the pre-defined risks for the buyer, options are not an appropriate investment for many people.
The fact that you can and may lose your entire investment in a short period of time hardly qualifies them as a low risk investment. Indeed, options should be regarded as a highly speculative investment. This doesn’t mean you should not consider options as an investment; some people have realized large profits by purchasing options when significant price movements are correctly anticipated. Moreover, it’s possible that gains realized on even a few profitable options could more than make up for losses incurred on other, unprofitable options.
As with any type of investment, it is important to be certain your decision is an informed decision. The following information is from the National Futures Association, a self regulatory organization of the futures industry, has been prepared to provide an introduction to options on futures contracts, how they work and the opportunities and risks associated with their purchase.
Table of Contents
- Part One: The Vocabulary of Options Trading
- Part Two: The Arithmetic of Option Premiums
- Part Three: The Mechanics of Buying and Writing Options
- Commission Charges
- The First Step: Calculate the Break-Even Price
- Factors Affecting the Choice of an Option
- After You Buy an Option: What Then?
- Who Writes Options and Why
- Risk Caution
- Offset the option
- Continue to hold the position
- Exercise the option
Part One: The Vocabulary of Options Trading
These are some of the major terms you should become familiar with, starting with what is meant by an “option.”Options – An investment vehicle that gives the option buyer the right, but not the obligation, to buy or sell a particular futures contract at a stated price at any time prior to a specified date.
There are two separate and distinct types of options: calls and puts.
Call – The buyer of a call option acquires the right to purchase a particular futures contract at a stated price at any time during the life of the option. Buyers of call options hope to profit from an increase in the futures price of the underlying commodity.
Put – The buyer of a put option acquires the right to sell a particular futures contract at a stated price at any time during the life of the option. Buyers of put options hope to profit from a decrease in the futures price of the underlying commodity.
Strike Price – Also know as the “exercise price,” this is the stated price at which the buyer of a call has the right to purchase a specific futures contract or at which the buyer of a put has the right to sell a specific futures contract.
Underlying Contract – This is the specific futures contract that the option conveys the right to buy (in the case of a call) or sell (in the case of a put).
Premium – The “price” you pay to purchase an option is known as the premium. Premiums are arrived at through open competition between buyers and sellers on the trading floor of the exchanges. A basic knowledge of the factors that influence option premiums is important for anyone considering option trading. The premium cost can significantly affect whether you realize a profit or incur a loss.
Expiration Date – This is the last day on which an option can be either exercised or offset. Be certain you know the exact expiration date of any option you buy. Options often expire during the month prior to the delivery month of the underlying futures contract. For example, an option on a July futures contract may expire on a specified date in June. Once an option has expired, it no longer conveys any rights. It cannot be either exercised or offset. In effect, the option rights cease to exist and the entire investment including transaction costs is lost.
Exercise – Exercising a call means that you elect to purchase the underlying futures contract at the option strike price. Exercising a put means that you elect to sell the underlying futures contract at the option strike price. If you choose to exercise an option you will acquire a position in the underlying futures contract – a long position if you exercise a call, a short position if you exercise a put. In either case, acquiring a futures position and potentially unlimited risks.
Offset – An option you have previously purchased can generally be liquidated (offset) through an offsetting transaction prior to expiration. You will realize a net profit if the premium you receive when you liquidate the option exceeds the premium you paid for the option by an amount greater than the commission charges plus other transaction expenses. As a practical matter, most options investors choose to realize their profits or limit their losses through an offsetting sale rather than through exercise. Unlike exercise, liquidating an option that you previously purchased does not involve acquiring a position in the underlying futures contract (which, as previously mentioned, can involve substantial risk.
Option Seller – Also referred to as the option “writer”. When you purchase the rights conveyed by a particular option, it stands to reason that there must be some other party who is willing to sell those rights to you. In fact, that is exactly what happens, with the transaction taking place on the trading floor of the exchange. The premium you pay to acquire the option rights goes to the seller who agrees to grant those rights. You should be aware that in contrast to the pre-defined and limited risk of buying options, sellers (writers) of options could incur potentially unlimited losses. Selling of options is thus not suitable investment for most people.
Commission – Commission is the sum of money per option purchased, that you pay to the brokerage firm for its services, including the execution of your order on the trading floor of the exchange. The commission charge is in addition to the option premium and should be separately stated.
Part Two: The Arithmetic of Option PremiumsAt the time your purchase a particular option, its premium cost may be, say, $1,000. A month or so later, the same option may be worth only $200 or $300 or $400. Or it could be worth $2,000 or $3,000 or $4,000. Since an option is something that most people buy with the intention of eventually liquidating (hopefully at a higher price), it’s important to have at least a basic understanding of the major factors which influence the premium for a particular option at a particular time. There are two, known as intrinsic value and time value. The premium is the sum of these.
Intrinsic value is the amount of money, if any, that could currently be realized by exercising the option at its strike price and liquidating the acquired futures position at the present price of the futures contract.
Ex. At a time when a U.S. Treasury bond futures contract is trading at a price of 90-00 ($90,000), a call option conveying the right to purchase the futures contract at a below the market strike price of 85-00 ($85,000) would have an intrinsic value of $5,000.
An Option that currently has intrinsic value is said to be in the money (by the amount of its intrinsic value).
Ex. At a time when a Treasury bond futures contract is trading at 90-00 ($90,000) a call option with a strike price of 85-00 ($85,000) will be “in the money” by its intrinsic value of $5,000. On the other hand, if the strike price of the call was, say 93.00 ($93,000) the option would be “out of the money” by $3,000.
What Is Time Value?
It’s the sum of money options buyers are presently willing to pay and option sellers are willing to accept from the specific rights that a given option conveys. It reflects, in effect, a consensus. It reflects, in effect a consensus opinion as to the likelihood of the option’s increasing in value prior to its expiration. The three principal factors that affect an option’s time value are:
Time Remaining Until Expiration: All else remaining the same, time value declines as the option approaches expiration. At expiration, it will no longer have any time value. This is why an option is said to be a wasting asset.
Relationship between the option strike price and the current price of the underlying futures contract: The further an option is removed from being worthwhile to exercise (the further out-of-the-money it is the less time value it is) likely to have.
Volatility: The more volatile a market is, the more likely it is that a price change my eventually make the option worthwhile to exercise. Thus, all else being the same, option time values and therefore premiums are generally higher in volatile markets.
Part Three: The Mechanics of Buying and Writing OptionsBefore you decide to buy and/or write (sell) options, you should understand the other costs involved in the transaction’s commissions and fees. Commission is the amount of money, per option purchased or written, that is paid to the brokerage firm for its services, including the execution of the order on the trading floor of the exchange. The commission charge increases the cost of purchasing an option and reduces the sum of money received from writing an option. In both cases, the premium and the commission should be stated separately. Each firm is free to set its own commission charges, but the charges must be fully disclosed in a manner that is not misleading. In considering an option investment, you should be aware of:
Commission can be charged on a per-trade or a round-turn basis, covering both the purchase and sale.
Commission charges can differ significantly from one brokerage firm to another.
Some firms have fixed commission charges (so much per option transaction) and others charge a percentage of the option premium, usually subject to a certain minimum charge.
Commission charges based on a percentage of the premium can be substantial, particularly if the option is one that has a high premium.
Commission charges can have a major impact on your chances of making a profit. A high commission charge reduces your potential profit and increases your potential loss. You should fully understand what a firm’s commission charges will be and how they’re calculated. If the charges seem high (either on a dollar basis or as a percentage of the option premium) you might want to seek comparison quotes from one or two other firms. If a firm seeks to justify an unusually high commission charge on the basis of its services or performance record, you might want to ask for a detailed explanation or documentation in writing.
Another concept you need to understand concerning options trading is the concept of leverage. The premium paid for an option is only a small percentage of the value of the assets covered by the underlying futures contract. Therefore, even a small change in the futures contract price can result in a much larger percentage profit (or a much larger precentage loss) in relation to the premium. Consider the following example:
An investor pays $200 for a 100-ounce gold call option with a strike price of $300 an ounce at a time when the gold futures price is $300 an ounce. If, at expiration, the futures price has risen to $303 (an increase of only one percent), the option value will increase by $300 (a gain of 150 percent on your original investment of $200).
But always remember that leverage is a twoedged sword. In the above example, unless the futures price at expiration had been above the optionâ€™s $300 strike price, the option would have expired worthless, and the investor would have lost 100 percent of his investment plus any commissions and fees.
The First Step – Calculate the Break-Even Price
Before purchasing any option, it is essential to precisely determine what the underlying futures price must be for the particular option to break even or become profitable if it is exercised. Without this information, there is no way you can make an intelligent decision about whether to buy the option.
The calculation isn’t difficult, there are only three things you need to know to figure a given option’s break-even point: (1) the options strike price, (2) the premium cost, and (3) the commission and other transaction costs you will be charged if you buy the option.
Determining the Break Even Price for a Call Option
Ex: It’s now January and the 1,000 barrel April crude oil futures contract is currently at around $17.50 a barrel. You expect that over the next several months there may be a significant price increase. That is, you believe that April crude oil futures prices will rise significantly above its present level. To profit if you are right, you are considering buying a call option with a strike the price of, say, $18 a barrel. Assume that the premium for that option is 90 cents a barrel (a total cost of $900 for the 1,000 barrel option) and that the commission and other transaction cost will be $100, which amounts to 10 cents a barrel. Before investing, you need to know exactly how far the April crude oil futures price must increase prior to the expiration of the option in order for the option to break even or yield a net profit after expenses. The answer is that the futures price must increase to $19 a barrel for you to break even and to above $19 for you to realize any profit. The option will exactly break even if the April crude oil futures price when the option is exercised is $19 a barrel. For each $1 a barrel the price is above $19, the option will yield a profit of $1,000. At the price below $19, there will be a loss. But in no case can the loss exceed the $1,000 total of the premium, commission, and transaction costs. *No representation is being made that the $100 commission charge used in this example necessarily typifies commission charges in the industry. Commission charges can vary dramatically from one firm to another.
Determining the Break-Even Price for a Put Option
The arithmetic is the same as for a call except that instead of adding the premium and transaction costs to the option strike price, you subtract them. Ex: The price of gold is currently just above $370 an ounce, but during the next few months, you expect a sharp decline. To profit from the price decrease if it occurs, you are considering the purchase of a put option with a strike price of $370 an ounce. The option would give you the right to sell a specified 100-ounce gold futures contract at a $3700 an ounce price at any time prior to the expiration of the option. Assume the premium for this particular option is $11.40 an ounce (a total of $1,140) and that the commission and transaction costs are $50 (equal to 50 cents an ounce). For the option to break even or yield a profit when exercised, the futures price must be $358.10 or lower, determined as follows: The option will exactly break even if the futures price is $358.10 when the option is exercised. For each $1 an ounce the futures price is above $358.10, there will be a loss. But in no case can the loss exceed $1,190-the sum of the premium ($1,140) plus the commission and other transaction costs ($50).
Factors Affecting the Choice of an Option
If you expect a price increase, you’ll want to consider buying a call option. If you expect a price decrease, you will want to consider buying a put option. But that’s only the first decision you will need to make. You’ll also need to decide on: The length of the option, and the option strike price.
The Length of the Option
One of the attractive features of options is that they provide time for your price expectations to be realized. The more time you allow, the greater the likelihood the option will eventually become profitable. This could influence your decision about whether to buy, say an option on March futures contract or June futures contract. Bear in mind that the length of an option (such as whether I has three months to expiration or six months) is an important variable affecting the cost of the option. All else being the same, a longer option commands a higher premium.
The Option Strike Price
At any given time, there may be trading in options with half a dozen or more different strike prices-some of them below the current price of the futures contract and some of them above.
Ex: At a time when the July soybean futures contract is quoted at, say, $6.00 a bushel, put and call options may be offered with strike prices of $5.50, $5.75, $6.00, $6.25,$6.50, and $6.75.
The relationship between the strike price of an option and the current price of the underlying futures contract is, along with the length of the option, a major factor affecting the option premium. All else being the same, a call option with a low strike price will have a higher premium cost than a call option with a high strike price, because it will more likely and more quickly become worthwhile to exercise.
Ex: The right to buy soybeans at $5.75 a bushel is more valuable than the right to buy soybeans at $6.00 a bushel. Conversely, a put option with a high strike price will cost more to purchase than a put option with a lower strike price. Another example would be the right to sell soybeans at $6.00 a bushel is more valuable than the right to sell soybeans at $5.75 a bushel.
How to Decide
An option with a short time to expiration or an option that requires a substantial price change in order to become profitable will be less expensive to purchase because of its lower premium cost. Consequently, if the anticipated price change fails to occur during the life of the option, your loss will be less. But such an option may have relatively little likelihood of becoming profitable prior to its expiration. On the other hand, paying a higher premium for an option with more time to expiration or with a more favorable strike price will increase the amount of money you have at risk and thus the size of your potential loss. Choosing which, if any, option to buy therefore demands careful figuring. At the very least, use the formulas presented earlier to calculate the break-even points of several different option alternatives, options with different strike prices and different lengths of time remaining to expiration. The final decision will ultimately come down to such considerations as our own analysis of the commodity’s price outlook, comparative premium costs, and how large an investment you are willing and able to risk. Options investments should be made with the same care and caution as any other investment, but with special attention to the reality that purchasing an unprofitable option could result in the loss of your total investment.
Offsetting an Option
An indicated, liquidating an option in the same marketplace where it was bought is the more frequent method realizing option profits. Liquidating an option prior to its expiration for whatever value it may still have is also a way to reduce your loss (by recovering a portion of your investment) in case the future price hasn’t performed as you expected it would or if the price outlook has changed. In active markets, there are usually other investors who are willing to pay for the rights your option conveys. How much they are willing to pay (it may be more or less then you paid) will depend primarily on (1) the current futures price in relation to the option’s strike price, and (2) the length of time still remaining until expiration of the option. Net profit or loss, after allowance for commission charges and other transactional costs, will be the difference between the premium you paid to buy the option and the premium received when you liquidate the option.
Ex: In anticipation of rising sugar prices, you bought a call option on sugar futures contract. The premium cost was $950 and the commission and transaction costs were $50. Sugar prices have subsequently risen and the option now commands a premium of $2,500. By liquidating the option at this price, your net gain is $1,500. That’s the selling price of $2,500 minus the $950 premium paid for the option minus $50 in commission and transaction costs. Buyers of options should be aware, however, that there is no guarantee that there will actually be an active market for the option at the time you decide you want to liquidate it. If an option is too far removed from being worthwhile to exercise and/or if there is too little time remaining until expiration, there may not be a market for the option at any price. Assuming, though, that there’s still an active market, the price you get when you liquidate will depend on the option’s premium at that time. Premiums are arrived at through open competition between buyers and sellers on the trading floor of the exchange.
Continue to Hold the Option
As previously indicated, you as the buyer of the option have the right to decide when you want to exercise or liquidate the option rights. The timing of excising or liquidatiing is entirely up to you. In fact, the right to continue to hold an option right up to the final date for exercising or liquidating it is one of the features that make options attractive for some investors. It means that even if the price change you’ve anticipated doesn’t occur as soon as you expected or even if the price initially moves in the opposite direction you have the assurance of knowing that the most you can lose by continuing to hold the option is the sum of the premium and transaction costs. Eventually, at some point prior to expiration, a change in the underlying futures price may make the option profitable. This is why it’s sometimes said option buyers have the advantage of staying power. You should be aware, however that all else being equal, options decline in value as they approach expiration.
Exercising an Option
As the buyer of an option, you can exercise the option at any time of your choosing prior to the expiration of the option. It does not have to be held until expiration. It is essential to understand, however, that exercising an option on a futures contract means that you will acquire either a long or short position on a futures contract. A long futures position if you exercise a call and a short futures position if you exercise a put.
Ex: you’ve bought a call option with a strike price of 70 cent a pound a 40,000-pound live pounds live cattle futures contract. The futures price has risen to, lets say, 75 cents a pound. Were you to exercise the option, you would acquire a long cattle futures position at 70 cents a pound ($2,000). And if the futures price were to continue to climb, so would your gain.
But there are both costs and significant risks involved in acquiring a position in the futures market. For one thing, the broker will require a cash margin deposit to provide protection against possible fluctuations in the futures price. And if the futures price moves adversely to your position, you could be called upon (as often as daily) to make additional cash margin deposits. Secondly, unlike an option which has limited risk, a futures position has potentially unlimited risk. The further the futures price moves against your position, the larger your loss. Even if you were to exercise an option with the intention of promptly liquidating the futures position acquired through exercise, there’s the risk that the futures price which existed at the moment may no longer be available by the time you are able to liquidate the futures position. Futures prices can and often do change rapidly.
Ex: You have a cattle call option with a strike price of 70 cents a pound. The futures price has now risen to 75 cents and you instruct your broker to exercise the option and promptly liquidate the position at a futures price of 75 cents. The risk is that by the time the position can be liquidated, the futures price ma no longer be 75 cents a pound. It may be substantially less than that.
For most of the reasons above, only a small percentage of option buyers elect to realize option-trading profits by exercising an option. Most choose the alternative of having the broker offset – i.e., liquidate – the option at its currently quoted premium value.
Who Writes Options and Why
Up to now, this booklet has talked about buying options. But it stands to reason that when someone buys an option someone else sells it. In any given transaction, the seller may be someone who previously bought an option and is now liquidating it. Or the seller may be an individual who is participating in the type of investment activity known as option writing. The attraction of option writing to some investors is the opportunity to receive the premium that the option buyer pays. This can be a profitable activity but it is also an extremely high-risk activity. Reason: If the option becomes worthwhile for the buyer of the option to exercise, the writer of the option is obligated to make good on his contract to acquire an opposite futures investment position. Such a position is almost certain to have a built-in loss. The amount of the option writerâ€™s loss could substantially exceed the amount of the premium income he received from writing the option.
Option writing is absolutely inappropriate for anyone who does not fully understand the nature and extent of the risks involved and who cannot afford the possibility of potentially unlimited losses. It is also possible in a market where prices are changing rapidly that an option writer may have no ability to control the extent of his losses. The same risk disclosure statement for futures and options that is required to be provided to buyers of options also describes the significant risks inherent in writing options.
Information Provided by the National Futures Association.