Best Way to Trade Options from Schmeg.com

   

An option gives us the right but not the obligation to purchase at a predetermined price. Options can be used on almost any type of investment, real estate, stocks, and the subject here; futures contracts.

An option on a futures contract gives us the right but not the obligation to purchase a futures contract at a given price called the strike price. An investor can establish a position on the market by purchasing an option without accepting unlimited risk that he or she may incur by owning the underlying futures contract i.e. a 20% decrease in the underlying futures contract an option owner is still has limited exposure, limited to what he paid for the option. Options on futures contracts are traded on the same exchanges as the underlying futures contract. Option buyers and sellers may liquidate their options at any time during market hours. Depending on our view of the market (which way is it going) we will purchase either a put (we think prices are going lower) or a call (we think prices are going higher). When an investor buys an option, he or she pays a premium (price) for the option. The premium is made up of intrinsic value (the amount of money the option is "in the money") and time value (the amount of time we have left until the option expires). The premium that an investor pays for an option when bought is the most he or she can lose (plus commissions) no matter how far the futures price moves against our bullish or bearish position. The time value and intrinsic value can best be explained in the following ex... The futures price is at 71 and the 70 call for the same underlying futures price is trading at 125 points then we have 25 points of time value and 100 point of intrinsic value.

Option premium = time value + intrinsic value

Time value - The amount of time an option has until it expires.
Intrinsic value - The relationship of the futures price to the strike price of an option.

Strike Price of an Option

Each option has what is called a strike price. Exchange traded options are offered at various strike prices, usually at round numbers, i.e. 260, 270, etc. Options are not only offered according to strike but also according to the month. The strike price is the price of the underlying futures contract that we will receive if we decide to accept (exercise) our right to receive the underlying futures contract.

Let's use an example, if we think the price of cotton is going higher and the futures price is currently trading at 70.00 then we could purchase a call option with a strike price of 71.00. For $1,000. This is called an out of the money call because the futures price is below the strike price. If we bought a call option with a strike price of 69.00 this would be considered an in the money option. If we purchased the call option with a 71.00 strike this would mean we have the right to purchase the futures contract at 71.00 before expiration

Table 1.1 will give you a clear picture on how to relate the strike price of a call option (a call buyer expects the underlying futures price to go up) to the underlying futures price.

Ex. 1 If the futures price is at 69.25          Strike 71.00 - out of the money          Strike 70.00 - out of the money          Strike 69.00 - in the money	Ex. 2 If the futures price is at 70.50          Strike 71.00 - out of the money          Strike 70.00 - in the money          Strike 69.00 - in the money
Ex. 3 If the futures price is at 71.90      Strike 71.00 - in the money      Strike 70.00 - in the money      Strike 69.00 - in the money
Table 1.1

Table 1.2 will give you a distinct picture on how to relate the strike price of a put (a put buyer is expecting the market to go down) option to the underlying futures price.

Ex. 1 If the futures price is at 69.75          Strike 71.00 - in the money          Strike 70.00 - in the money          Strike 69.00 - out of the money	Ex. 2 If the futures price is at 70.50          Strike 71.00 - in the money          Strike 70.00 - out of the money          Strike 69.00 - out of the money
Ex. 3 If the futures price is at 71.75 Strike 71.00 - out of the money Strike 70.00 - out of the money Strike 69.00 - out of the money
Table 1.2

An option will obviously vary in price depending on how much intrinsic value and time value is remaining in the option's life. If a trader was comparing prices on options of the same commodity but with different delivery months and strike prices there would be noticeably different prices on each strike price and each delivery month. An option that has 4 months until expiration will have more time value than an option with 1 month left until expiration therefore the option with 4 months remaining until expiration will have more time value and should reflect this in its premium (price). An option that is further in the money will have a greater intrinsic value than one that is out of the money therefore this difference will be reflected in price.

Now let's take a look at what we call the Greek terms of option trading. The three Greek terms we will take a look at are DELTA, GAMMA and THETA. The Delta is the percentage that the option moves with the underlying futures contract. Example: a delta of 20 would imply that for every 100 points that the future's contract price moves the option will move 20 points. An option that is at the money will have a delta of 50. (For every 100 points the futures price moves the option will only move approximately 50 points. An option that is at the money will have a delta of 50. As time approaches the expiration the delta will increase to 1.00 for in the money calls and puts. Contrarily the delta for out of the money puts and calls will approach 0. We will talk about the delta and how to make the delta work for you in the next section.

• Theta-The rate at which an option decays over a period of time.
• Gamma -The rate of change of the delta

Option Writing

Just like a futures contract, an option must have a buyer for every seller, (remember an open interest of 1 means there is 1 long and 1 short), options also have an open interest. If an investor buys an option he is said to be "long" the option. If an investor sells an option that he doesn't already own he is short the option, an option seller is also called an option writer or grantor. An option purchaser has limited risk whereas an option writer has unlimited risk and limited profit potential. When an option purchaser buys an option the seller will collect the premium. If the option expires worthless the buyer loses his premium plus commissions paid and the seller receives the full amount of the premium less commissions. See Example:
Investor "A" buys a copper option expiring in Dec with a strike price of 104 copper for $250, the most he can lose is $250. Investor "B" sells (writes) the same option and collects the $250. Now, the most investor "B" can make is $250, on the other hand, if the option expires worthless at expiration the buyer will lose $250 and the grantor will make $250.
If the option increases in value to $500 the buyer will obviously have a profit of $250 excluding commissions, whereas, the grantor will be holding a loss of $250.

Buyer has limited Risk and unlimited profit potential.
Seller has unlimited risk and limited profit potential.

At this point you may be asking yourself why anyone would want to acquire a position that has limited gain and unlimited risk? Well the answer lies in the notion that most out of the money options expire worthless; as option sellers, although we do have unlimited risk, this does not mean that we have to watch a position work against us without doing any thing about it. As option sellers we may buy back the options at any time, given, we are not in a limit move. Your broker should be in a position to set a trade alert on an option price so that once your risk level is at an intolerable level he or she can call you or buy it back for you based on your previous instructions. In order to better explain, let's use the graph below on Lean Hogs to view the distance of price and strike price relative to the time remaining on an option.

On the above chart if the futures price moves up 100 points then our option that we sold with a 6200 strike price for $200 will work against us by approximately 20points (delta of .2 times 100pts), compared to 100 points with a futures contract. Assuming a point value of $4.00 per point then we would have a drawdown of $400 on the futures contract (the amount the futures position moves against the investor) compared to an $80 drawdown if we had an option. Because of the delta, we will experience a smaller drawdown with a short call rather than a futures position. The Delta will not however, stay constant at 20% because of the Gamma.

Volatility

Before we move any further let us briefly explain volatility. There are two types of volatility, historical and implied. Historical volatility measures the range of a futures price over time. Implied volatility reflects the markets consensus of expected volatility.

Option markets with high volatility generally provide us with better option selling opportunities. During high volatile markets, buyers are willing to pay more for the likely hood of the underlying futures contract moving a greater distance, whereas sellers are more likely to want higher premiums because of the risk of the underlying futures contract moving a greater distance.

If we have an option that has implied volatility of 20%, this means the underlying futures price two thirds of the time will most likely be within a 20% higher or lower range then the current price within one year.

Option highlights

Percentage increase and decreases in volatility may help in factoring market turning points or oversold and overbought conditions.

Volatility ratios can be important in detecting market tops or bottoms. Percentages that volatility increases or decreases can help us detect possible market turning points.

An option loses the greatest amount of time in the last 45-30 days of its life. See graph.

The last 30-45 days of an options life is an ideal time for option sellers that are holding options far away from the money because this is when we experience the greatest amount of time decay.

The best opportunities come in high volatile markets because of the premium that buyers are willing to pay for the chance of their option strike price coming into the money, or as a hedge against a futures position.

Below is a list of various option strategies:

• Long call - Buy a call; you are expecting the underlying futures price to go higher.
• Long put - Buy a put; you are expecting the underlying futures price to go lower.
• Short call - sell a call that you do not own; you are bearish on the underlying futures market or at least not expecting the market to rise to your strike price that you sold.
• Short Put - sell a put that you do not own; your are bullish on the underlying futures market or at least not expecting the futures market to go to your strike price.
• Bull call spread - Buy a near the money call and sell an out of the money call.
• Bear Put spread- Buy a near the money put and sell an out of the money put.