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July 1, 2011 by Leave a Comment

An Option’s Delta. What Is It and What Does It Tell You?

Many traders have heard about an option’s delta, but they have no idea what it means or how they can implement it in their own trading strategy.  An option’s delta will give you the rate of change for an option, the hedge ratio for an option and an option’s theoretical equivalent to the underlying futures position.  This article will focus on helping traders become familiar with an option’s delta and its many uses.

Please click to view the Options risk disclosure below.

Delta is given as a value and quoted with a decimal will call options being from 0 – 1.00 and put options from 0 – (-) 1.00.  However, the decimal is commonly dropped when being discussed and we’ll do the same in this article.  For call options, the value ranges from 0 – 100.  For put options, it ranges from 0 – (-) 100.  A call (put) option with a delta of around 50 (-50) is referred to as an at-the-money option.  A call (put) option with a delta between 0 – 49 (0 – (-) 49) is referred to as an out-of-the-money option.  A call (put) option with a delta between 51 and 100 (-51 and -100) is referred to as an in-the-money option.

Delta helps traders figure out the rate of change for an option compared to the underlying futures position.  The underlying futures position will always have a delta of 100.  If a call option has a delta of 35, it can be expected to change in value at 35% of the rate of the underlying futures position.  Simply, if the underlying futures rises 1.00, the call option can be expected to rise by .35.  As an option increases in value, the delta will change and begin moving more like the underlying position.

Delta also helps traders figure out a hedge ratio.  This is when a trader wants to hedge an option position against the underlying futures contract, also known as being ‘delta neutral.’  Since the underlying contract always has a delta of 100, the hedge ratio is determined by dividing 100 by the options delta.  If an options delta is 50, then the hedge ratio is 100/50, or 2/1.  For every two options purchased, the trader would need to sell one underlying futures position to establish a neutral hedge.  To learn more about delta neutral trading, read my previous article:  Futures Options: Using a Delta Neutral Trading Strategy.

Please click to view the Options risk disclosure below.

Delta also helps traders figure out what an options theoretical equivalent is to the underlying futures position.  Since the underlying futures position has a delta of 100, each 100 deltas in an option position represents a theoretical position equivalent to one underlying contract.  If a trader has an option that has a delta of 50, the option is the theoretical equivalent of holding 50% of an underlying contract.  Delta also gives you the approximate percentage an option has of ending up in-the-money.  If a call option has a delta of 40, then the option has approximately a 40% chance of ending up in-the-money.  If a put option has a delta of -68, it has approximately a 68% chance of ending up in-the-money.  The closer the delta is to 100 for calls and -100 for puts, the greater the chance it has at ending up in-the-money.  Deltas that are closer to zero indicate that the option has less of a chance to end up in-the-money.

As you can see, an option’s delta can tell you many things.  It can tell you the rate of change for an option compared to the underlying position, the hedge ratio, and the theoretical equivalent to an underlying position along with the percentage chance it will end up in-the-money.  All of these can be helpful in understanding how an option moves.

Gain Access to 21 Detailed Futures and Options Strategies

What’s your trading strategy? To discover how to structure your trades, download your complimentary guide from Daniels Trading for helpful advice on using futures and options.  Sign up to get the free ‘Futures and Options Strategy Guide’.

Options Risk Disclosure:  When selling options, you may lose more than the funds you invested.

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Filed Under: Options, Risk, Strategies Tagged With: , ,
June 30, 2011 by 1 Comment

Should I Trade with Futures or Options?

Many new traders have a hard time figuring out whether they want to enter a trade using a futures contract or by purchasing an option. Some like the potential futures offer while others like the limited risk that comes with purchasing a call or a put option. This article will explain the two and help you to figure out what scenarios might be more appropriate for trading a futures contract and buying an option.

A futures contract is an agreement to buy or sell a particular commodity in the future at a pre-determined price. If you think the price of a commodity is going to rise, you would want to buy a futures contract. If you think it will fall, you would want to sell a futures contract. You can sell­-or ‘short’–a market just as easy as you can buy–or go ‘long’–a market. A futures contract can be appropriate for most trading scenarios. It is good for swing trading­holding a position overnight­as well as day trading; that is, getting in and out of a position during the same trading day. However, a futures contract might not be appropriate when there is a market report coming out. An example of this is the monthly Crop Production report. This report can really move markets and does at times result in limit moves. A limit move is a predetermined limit that a market can move in a single trading day. For corn, the limit is 30 cents. A 30 cent move in corn is a $1,500 move. If that is too much risk for you in a single day, buying an option can be a viable alternative.

An option is the right, not the obligation, to buy or sell a futures contract at a designated price. Purchasing a call gives you the right to buy a futures contract at a designated price. Purchasing a put gives you the right to sell a futures contract at a designated price. To learn more about purchasing options, read my previous article: Options on Futures: An Introduction to Buying Options. One of the beautiful things about purchasing options is that your risk is limited to what you paid for the option. A futures contract, on the other hand, has unlimited risk. If you are not comfortable with the unlimited risk that is associated with futures, purchasing an option would be more appropriate for you. As discussed above, purchasing an option may also be an attractive alternative to a futures contract when a market report is about to be released. You can have a position in a potentially volatile market while having the comfort that comes with limited risk. One scenario that may not benefit an option purchaser is the fact that an option is a wasting asset. If the call or put you purchased is just one tick out of the money, it will expire worthless and all of the premium paid will be lost.

These are just a few of the scenarios that many traders face when trying to decide on whether to use a futures contract or purchase an option to enter a trade. Both futures and options have their advantages and disadvantages under certain scenarios. If you decide to use a futures contract in your live account, paper trade the option to see how it differs. This will help you to figure out what style is appropriate for you risk tolerance and trading philosophy.

Gain Access to 21 Detailed Futures and Options Strategies

What’s your trading strategy? To discover how to structure your trades, download your complimentary guide from Daniels Trading for helpful advice on using futures and options.  Sign up to get the free ‘Futures and Options Strategy Guide’.

Please click to view the Paper Trading risk disclosure below.

Paper Trading Risk Disclosure:  BEING A SUCCESSFUL PAPER TRADER DURING ONE TIME PERIOD DOES NOT MEAN THAT YOU WILL MAKE MONEY WHEN YOU ACTUALLY INVEST DURING A LATER TIME PERIOD.  MARKET CONDITIONS CONSTANTLY CHANGE.

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Filed Under: Getting Started Tagged With: , , ,
June 29, 2011 by 1 Comment

Credit Spreads: Collect Premium while Keeping Your Clothes On

Readers of this blog should be very familiar with option spreads. We have written in the past (Option Spreads Examined Further: Measured Ways to Play Your Market Hunch, Bear Put Spreads: An Alternative to Purchasing Puts, and Bull Call Spreads: An Alternative to Purchasing Calls) about the different ways traders can participate in leveraged markets with measured risk strategies. In all of those cases, we looked at the buy side of those spreads in order to capture a high rate of return with a lower, set amount of risk. Those strategies should always be in a trader’s tool belt, but we cannot be quick to dismiss the other side of those trades, or the sell side option spread, known better as the credit spread.

Please click to view the Spreads risk disclosures below.

There will always be a place for buying options. However the option is used, if for protection or outright speculation, buying an option provides the opportunity to have unlimited returns with a set amount of risk. I encourage traders to buy options as opportunities are presented. Occasionally, however, the markets are trading with big daily ranges and high volatility, options get “bid up” and the cost due to volatility gets too high. In those cases, it might be better to simply “fade” that volatility by selling options and collecting premium.

Please click to view the Options risk disclosures below.

A sale of an option without any other position is known as a naked short option. The naked short option strategy is used as a way to make money based off where the market will not go. The strategy can be profitable, but over the long run it can bring sharp drawdowns or even the dreaded “account debit” if not properly managed. The problem Daniels Trading has with naked option selling is that it carries unlimited risk. Strategies, such as out of the money naked option selling, have a high probability of success which provide small gains that add up. Sure, there are people who have been successful constantly selling naked options. However, ask anyone who sells option premium in the Crude Oil markets during a supply shock, or someone who sold on short puts in the S&P before the Lehman Brothers bankruptcy, what their opinion is on that type of strategy and they will undoubtedly describe the feeling they had as one akin to being tied down with the market bearing down on them like a train rumbling down the tracks. It is impossible to predict the black sheep that create major market swings and the naked option sellers do not need many losers to be out of liquidity and out of the markets for good. One of Daniels Trading’s senior brokers often makes the great analogy that “[s]elling naked options makes an account’s value go up like an escalator and down like an elevator”.

These two types of spreads provide the opportunity to collect premium while still giving them protection so they can handle the unpredictable and inevitable market events. By selling out of the money-option spreads, one is taking on a higher amount of risk for a lower return, but the odds for success will also be higher. Let us look at an example:

Please click to view the Options and Spreads risk disclosures below.

Ken has $10,000 in an account. He is looking for a trade with a high probability of success. Over the last few days Ken has been watching the December Corn contract sell off from above 7.00 to below 6.30, which has left the bulls screaming for put protection. Ken is a fundamental trader and he has done some analysis, which in his opinion confirms that prices in corn will not fall below 6.00 before the December options expire. He wants to take a long position.  Still, he feels like a futures contract would not be a great strategy because if he is wrong he could be taken out of his position quickly; thus, he is susceptible to the “whipsaw” effect. He decides selling a put spread will provide greater margin flexibility and fits his risk profile better. While December Corn was in the midst of a sell off at 6.30, he decided to sell a 5.50-6.00 put spread in the December Corn options for 21 cents:

Sold 1 Dec 600 put for 46 ($2300)
Buy 1 Dec 550 put for 25 ($1250)
Max profit= 21 Cents ($1050)
Max loss=29 cents ($1450)

Ken’s breakeven is 5.79. He suffers a max loss if his December Corn options expire with Corn anywhere below 5.50. Ken knows his reward is not as high as his risk, but his analysis shows that Corn will stay over 6.00. So, he feels comfortable risking $1450 because Corn will stabilize somewhere over the 6.00 strike price where he sold the put. He also feels comfortable because he can let the markets workout what is taking corn lower. Ken is unconcerned with where he will be next week because his focus is on where he will be in four months. In the worst case scenario, Corn sells off below 6.00 and Ken can lose no more than $1450 dollars on expiration. If December Corn expires over his 6.00 short put, Ken is probably satisfied with the 10% profit he earns over the next five months. Another benefit to the trade is that Ken knows he has an additional $8,000 in free margin which he can use on other trades.

Tips for Trading Credit Spreads

Here are a few simple tips that can help you improve your chance for success and allow you to potentially capture the most profit possible:

Please click to view the Profits risk disclosure below.
  • Sell into heavy price moves. When the market is violent options buyers will often pay more for protection from volatility. The best markets in which to use this strategy are those that have had unsustainable recent price action.
  • Do not put all of your eggs in one basket. Diversify your spreads across multiple uncorrelated markets. Try to look for the markets that are driven by uncertainty.
  • Make sure your account is properly capitalized. Always choose spreads that your account can handle, especially if a max loss occurs.
  • Try to sell option spreads at least 30 days before expiration. The time value is higher and this value comes out of the option price on an accelerated level as expiration nears.

These tips can help generate consistent profits which can add up over time. When the next black sheep event occurs–they always do when we least expect–these tips may protect you from a debilitating drawdown. Remember, there are two key goals to trading: the first goal is to make money and the second is to keep it. This tips can help achieve both of those objectives.

Gain Access to 21 Detailed Futures and Options Strategies

What’s your trading strategy? To discover how to structure your trades, download your complimentary guide from Daniels Trading for helpful advice on using futures and options.  Sign up to get the free ‘Futures and Options Strategy Guide’.

Spreads Risk Disclosure: A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts. It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread). In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

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Options Risk Disclosure: An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price. Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different. For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option. Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options). Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised. The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero. Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received). The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

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Profits Risk Disclosure: Past results are not necessarily indicative of future results.

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Filed Under: Options, Spreads, Strategies Tagged With: , , , , ,
June 8, 2011 by 2 Comments

Option Spreads Examined Further: Measured Ways to Play Your Market Hunch

New option traders tend to overlook the strategy of combining two options to form spreads, which allow different degrees of market optimism or pessimism.  Option spreading is different than futures because a straight futures play only portrays one degree of bullishness/bearishness.  If one is long the futures, he better be very sure the market is going up from the moment he is filled on the position.  Sure, there are risk measurement tools we all use to make sure we don’t lose the farm, and no one can always picks the exact top and bottom, but when it comes down to analyzing trade setups, there is no reason to buy or sell a futures contract unless you have a strong conviction the market is going to go in the direction you think it will immediately.

Please click to view the Options and Spreads risk disclosures below.

Unfortunately, many traders have a hard time garnering that much conviction.  Some see various degrees of bullishness or bearishness in the marketplace, either due to fears of certain economic events or sentiment changes in the marketplace.  Therefore, they can’t bring themselves to buy the futures outright.  If this is the case, then a bull call spread or a bear put spread may be a better way to capture gains.  (If you have been a follower of this blog you should be familiar with these spreads, if not you can read the articles on bull call spreads and bear put spreads to get the basics behind each strategy.)

The Structure of the Spread is Very Important

When applying these strategies, the amount of bullish/bearish sentiment can be measured by the difference between the option bought (closer to the money) and the option sold (further from the money).  It is very important to have a specific plan in place; just picking arbitrary strikes will affect the risk/reward potential.  In options trading always apply the adage, “there is no such thing as a free lunch”.  That means the more you pay for the spread, the higher the profit or loss potential.  When placing a spread trade it is important to be careful about the strikes chosen, the trade setup should reflect how bullish or bearish you are.

When you place the option sold closer to the option purchased, you will lower the cost of the spread, but by doing so you will lower the spread’s earning potential.  If you place the option sold further away, you may have the opportunity for big gains but you are risking more to realize those gains.  The spread between the prices of different strikes will be determined by a few factors, but to make life easier I like to look at the difference in market delta between the option bought and option sold as my primary indicator (learn more about market delta).

A good rule of thumb trader’s use is called the “.20 to .30 delta rule.” This rule implores the trader to look at the deltas of each option, subtracting the delta of the purchased option from the delta of the sold option.  Ideally the difference should come out to be somewhere between .20 and .30.  The closer to .20 indicates that the spread is on the conservative side, the closer to .30 indicates it is on the aggressive side.  Sure, you can buy spreads with higher and lower deltas than .20 and .30, but in those cases bear put and bull call spreads may not be the best strategy.  Keep in mind these deltas change daily, it’s important to have this data handy before executing the trade.

Compare Plans

Trader Ann is bullish gold.  She believes that over the next two months the market will see a price appreciation of somewhere between 4% and 7%, but due to the uncertainty of the Federal Reserve policies and the European debt issues she worries she might have to whether some volatility in the meantime.  She believes picking tops and bottoms is a loser’s game, and knows she doesn’t have the stomach (nor the wallet) to afford a futures contract outright.  At of the close of the market today gold is trading at 1525, which would place her target anywhere between 1585 and 1620.  She has $10,000 dedicated to her trading and doesn’t want to risk more than 30% of the liquidity in her account on the trade.  Because she has a two month timeframe in mind, we will look at the August Gold calls that expire in 60 days.  For this example we will look to buy an “at the money” call and sell an “out of the money” call at one of the strikes mentioned above.  Ann will call her Daniels broker and price out a few different plans and decide which is best for her.  Let’s compare our two plans and see which one is more appropriate:

Plan #1
1525-1585 August Gold Call Spread
Purchase One August Gold 1525 Gold Call for $4100 with a delta of .51
Sell One August Gold 1585 Gold Call for $2000 with a delta of .30.
Total premium paid for the spread is $2100, which will initially trade with a delta of .21

Max profit= $6000 (total gain between 1525 and 1585) – $2100 (cost of spread) = $3900
Max loss= $2100 (cost of spread)

Plan #2
1525-1620 August Gold Call Spread
Purchase One August Gold 1525 Gold Call for $4100 with a delta of .51
Sell One August Gold 1620 Gold Call for $1300 with a delta of .21
Total premium paid for the spread is $2800, which will initially trade with a delta of .30

Max Profit= $9500 (total gain between 1525 and 1620) – $2800 (Cost of spread) = $6700
Max loss= $2800 (cost of spread)

Please click to view the Hypothetical Performance disclosure below.

Ann can now see by looking at the delta comparisons, how much she will make or lose initially from the option spread as the underlying futures prices move higher or lower.  The larger the delta on the spread, the more profit/loss she will take from a one point move in the August gold futures contract.  Based off these numbers she can apply them to her level of bullishness in Gold.  If she believes the market is more susceptible to an immediate move up she will enter the market via Plan #2.  If she feels a little apprehension about the short term prospects of gold she would probably be better off entering via plan #1.  Keep in mind Ann wants to participate now, she doesn’t want to try to perfectly try to time an entry.  Either way, she will get the exposure to the gold markets immediately, allowing her to handle the market swings as they come.

If she is correct and the market moves higher she will profit, if she is wrong and the market moves lower she will lose, as any directional trades result.  But Ann is more focused on where Gold will be in August and not today.  She obviously would rather be correct sooner rather than later, but as we learned about these spreads from past articles, they allow for the market to do its thing without worrying of a margin call.

As always, leverage cuts both ways and it is important to know exactly what you have on the line with each trade.  The way you establish these spreads should reflect your market sentiment.  If you have any questions on the strategies mentioned above or finding the delta on specific options please contact your Daniels Trading broker.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

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Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

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HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW.  NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.  IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.  ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT.  IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING.  FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS.  THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

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Filed Under: Options, Spreads, Strategies Tagged With: , , , , ,
June 7, 2011 by Leave a Comment

Locking in Profit by Purchasing Options

One of the most common things you’ll hear a futures trader say is, “Make sure you lock in profits with stops!”  One thing some traders don’t realize is that you can lock in profits with options as opposed to using just a stop loss order.  This article will focus on how locking in profits is done and when it may be a useful strategy.

How it works

The most common way to lock in profits using options is done by purchasing an out-of-the-money call or put wherever you’d like to lock in profit.  An option gives you the right to buy or sell a futures contract from a specified price.  If you are long a market, you would want to purchase a put to lock in profit.  If you are short a market, you would want to purchase a call to lock in profit.  The amount of profit you will lock in is determined by the strike price plus the premium paid.

When This Strategy is Appropriate

A trader can use options to lock in profits any time they would like to.  However, they can be especially useful when a trader is expecting high volatility in the market they are trading.  Let’s say you are in a long futures position in the corn market and a crop progress report is due out in a few days.  You think there may be a short term correction in the market before it continues on its bullish trend.  You can simply purchase a put at whatever point you would like to lock in profits (remember to keep premium paid in consideration here).  If the market report comes out bearish and the market doesn’t continue in the bullish trend, simply exercise the put option to offset your long futures position at the strike price purchased.

Example

Frank is a speculator who is currently trading the corn market.  He has been long July 2011 corn from a price of $6.72.  July corn last traded at $7.50 and Frank would like to lock in some profit.  Since he is long the corn market, he knows he will need to purchase a put to lock in profits using options.  Frank would like to lock in around $2000 of his profits.  A $7.30 July corn put option is currently trading at 19 cents premium.  Each cent is equal to $50 in the corn futures and options market.  Knowing this, Frank decides to purchase the $7.30 put to lock in profits.

$7.30 (Put option purchased)
-0.19 (Cost of put option)
$7.11 (Price locked in after difference in strike and premium paid)
-6.72 (Initial long position)
$0.39 of profit locked in, or $1,950 (39 * 50)

Summary

Using options to lock in profits is a simple alternative to using futures positions.  They can give you the ability to ride out volatility swings with a defined exit point without having your position offset like you might with a futures stop loss.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Stop Orders Risk Disclosure:  This website may make certain references to the use of stop orders as means of limiting losses or protecting profits.  Please note that there is no guarantee that any stop loss order will be executed at the stop price.  Therefore, there can be no guarantee that placing a stop order will limit losses or protect profits.  Accordingly, no representation is being made that the trading in customers’ accounts will be profitable or will not result in losses as the result of placing stop orders.

Filed Under: Options, Strategies Tagged With: , , , ,
May 20, 2011 by 15 Comments

Bear Put Spreads:  An Alternative to Purchasing Puts

Options are a great way to get involved with the futures markets.  One of the most popular ways to trade with options is to buy puts.  This provides traders a way to trade the futures markets with a defined risk and unlimited profit potential.  One of the downfalls of purchasing puts is that they can be expensive if you purchase them at-the-money (If you need a refresher on purchasing options, see my previous article here:  Options on Futures:  An Introduction to Buying Options.  One way to reduce the price of an option is to use spreads.  This article will teach you how to implement bear put spreads into your trading strategy.

What is a Bear Put Spread?

A bear put spread is a position that involves purchasing a put option on an underlying futures contract, while simultaneously writing a put option on the same underlying futures contract with the same expiration month, at a lower strike price.  As the name of the strategy hints, this is a position that is appropriate for a bearish market sentiment.

Why not just purchase a put?

This is one of the most common questions posed when a trader is first learning about bear put spreads.  Bear put spreads allow a trader to pay less premium to get involved in a position than simply purchasing a put.  If a trader has a smaller account, it will also allow them the opportunity to get involved with a put that is closer to at-the-money.

How it works

As noted above, a bear put spread deals with the simultaneous purchase and sale of options on the same underlying futures contract in the same expiration month at different strike prices.  Why is this done?  The trader obviously pays for the purchase of the put, but they also receive premium for selling a put as well.  For a bear put spread, a trader would typically purchase an at-the-money put and sell an out-of-the-money put to initiate a bear put spread.  The selling of the out-of-the-money put helps the trader finance the purchase of the at-the-money put.  The maximum profit would be the difference between the strike prices of the options minus the amount paid for the spread.

Example

Gary has a bearish sentiment on the crude oil market.  He decides the most cost effective way to get involved in the market is to enter a bear put spread.  Gary decides to get involved in July crude oil as it provides a reasonable time frame for the move he thinks will occur.  July crude oil futures are currently trading at 99.31.  Larry decides to enter a 99.00/90.00 bear put spread.  See below for the specifics on the options:

Purchase One July 99.00 Crude Oil Put Option for $3,920 (Pay)
Sell One July 90.00 Crude Oil Put Option for $1,130 (Collect)

Total Premium Paid for Position = $2,790 (3920 – 1130)

Gary’s maximum profit on the trade is the difference in the strike prices minus the total premium paid.

$9,000 Difference in futures price (9*1000)
-2,790 Premium paid for call spread
$6,210 Maximum profit potential

Gary’s maximum risk is the $2,790 he paid to enter the spread.

This spread will realize maximum profit at expiration if the July crude oil futures market is trading at under 90.00.  The options will be exercised, offsetting each other at the strike prices assigned to each option.  See below for how this would work at expiration:

  • July 99.00 crude oil put expires on June 16th, the option is exercised and Gary’s account is short crude oil futures contract from 99.00.
  • July 90.00 crude oil put expires on June 16th, assigning Larry’s account a long crude oil futures contract from 90.00.
  • The short 99.00 July crude oil futures is immediately offset by the long 90.00 July crude oil futures contract, allowing Gary to show a futures gain of $9,000 (9 * 1000).
  • Gary’s realized profit is the gain in the spread offsetting by the cost of the spread, or $6,210.

Conclusion

As you can see, there are opportunities in the options market using the bear put scenario above.  It offers a great way to get involved in options at a desirable strike price with a limited risk.  You don’t have to wait until expiration to exit the spread.  You can exit any time you’d like to limit losses or collect profits before expiration.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Spreads, Strategies Tagged With: , , , ,
May 18, 2011 by Leave a Comment

5 Tips for Option Writers

Tip 1:  Have a Disciplined Plan

Writing options should not be treated any different than any other type of investment.  You must plan your trade and trade your plan.  That being said, you must determine the profit and risk parameters around each trade.  In the case of writing options, your maximum profit is the premium collected upfront.  The struggle many option writers face is how to manage the position when the market begins moving against them.

Writing naked options are one of the most difficult strategies to manage because the risk is unlimited.  Leveraged markets, like the futures markets, can move very quickly, which can make it extremely difficult to properly manage risk.  Even if you have a mental stop to cut your losses, a severe move in the market might not allow you to exit at that point.  Premiums can double or triple before you have a chance to buy back the option.  This is why it is so important to have a concrete plan in place.  In the event a market does move against you, your trading plan will allow you to act quickly to prevent further damage.

If the concept of unlimited risk is unappealing, one solution to naked options would be credit spreads.  Credit spreads have predetermined trade parameters on both the profit and loss side of the trade.  You can easily determine your best and worst case scenario upfront.  The majority of options will expire worthless, but that doesn’t mean the position won’t go through its ups and downs.  By accepting the risk/reward parameters of the spread, you should be comfortable sitting through the day to day fluctuations and only make modifications if your long term outlook changes.

Tip 2:  Control Your Leverage

Options provide a fantastic opportunity with leverage; however it is important to be smart in how to use this leverage.  A unique obstacle option writers must overcome is margin.  Unlike the underlying futures, margin designated to selling options is not a flat rate.  Instead, margin is determined by SPAN.  SPAN is a set of sophisticated algorithms that determine margin according to your positions one day risk.  The distance a strike price is to the underlying, the time left until expiration, and volatility are all factors that can affect our margin.  That being said, margin is simply a guideline.  This is why leverage is so important.  You might be properly leveraged according to your margin on day one, but as time goes by and as the underlying futures moves, the margin can drastically change.  Dramatic, volatile moves can cause traders to exit positions early due to margin calls.  The greater the leverage, the more sensitive your position is going to be to these price swings.  This is another reason why many traders prefer credit spreads.  Credits have a defined risk and will in turn have less severe margin swings.

Tip 3:  Do Not Hang on to Worthless Options

The point of writing options is to collect the time premium and allow the value of the option to decay.  Although the goal is to have our options expire worthless, it does not mean we cannot buy the option back early.  This is especially true when there is a lot of time left on the option.  If 80-90% of the total options value has decayed, it does not make sense to keep on the risk of the position for the extra 10-20%.  There are certain strategies that will require holding the options until expiration, but unless your strategy involves writing far out of the money options for a few ticks, it would likely make sense to take the risk off the table.  It is important to continually reevaluate the risk and the management of the trade throughout the life of the position.

Tip 4:  Be Aware of Major Reports and Events

Whether you are a technical trader or a fundamental trader, you must be aware of key market reports and events.  You should have access to an economic calendar that will identify all scheduled reports.  We will need to keep these dates in the back of our minds when analyzing our trades.  As discussed in our last tip, if the majority of our option’s premium has been removed prior to a report, it might be best to take the risk off the table in case the report is extremely one sided.

Tip 5:  Choose Markets You are Comfortable With

We should have a good understanding of the markets current trend and the long term fundamental picture.  An awareness of the fundamentals, scheduled reports, and key technical areas (trend lines, moving averages, pivots, etc.) are vital aspects of how we analyze our trade.  The more comfortable we are with what is driving the market, the more confident we can be with our analysis.  The more we trust our analysis, the easier it will to evaluate our position and determine if a sudden move is a short burst in the market or the beginning of a new trend.  We should have a good feel for the market’s volatility and typical trading range, so we can identify when the current market environment begins to change.  This comfort and knowledge should help you stay more disciplined and follow the trading plan established upon entering the trade.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Strategies Tagged With: , , , , ,
May 17, 2011 by Leave a Comment

Bull Call Spreads: An Alternative to Purchasing Calls

Options are a great way to get involved with the futures markets.  One of the most popular ways to trade with options is to buy calls.  This provides traders a way to trade the futures markets with a defined risk and unlimited profit potential.  One of the downfalls of purchasing calls is that they can be expensive if you purchase them at-the-money (If you need a refresher on purchasing options, see my previous article here: Options on Futures:  An Introduction to Buying Options).  One way to reduce the price of an option is to use spreads.  This article will teach you how to implement bull call spreads into your trading strategy.

What is a Bull Call Spread?

A bull call spread is a position that involves purchasing a call option on an underlying futures contract, while simultaneously writing a call option on the same underlying futures contract with the same expiration month, at a higher strike price.  As the name of the strategy hints, this is a position that is appropriate for a bullish market sentiment.

Why not just purchase a call?

This is one of the most common questions posed when a trader is first learning about bull call spreads.  Bull call spreads allow a trader to pay less premium to get involved in a position than simply purchasing a call.  If a trader has a smaller account, it will also allow them the opportunity to get involved with a call that is closer to at-the-money.

How it works

As noted above, a bull call spread deals with the simultaneous purchase and sale of options on the same underlying futures contract in the same expiration month at different strike prices.  Why is this done?  The trader obviously pays for the purchase of the call, but they also receive premium for selling a call as well.  For a bull call spread, a trader would typically purchase an at-the-money call and sell an out-of-the-money call to initiate a bull call spread.  The selling of the out-of-the-money call helps the trader finance the purchase of the at-the-money call.  The maximum profit would be the difference between the strike prices of the options minus the amount paid for the spread.

Example

Larry has a bullish sentiment on the gold market and believes it will continue in its bullish ways.  He decides the most cost effective way to get involved in the market is to enter a bull call spread.  Larry decides to get involved in July gold as it provides a reasonable time frame for the move he thinks will occur.  July gold futures are currently trading at 1512.5.  Larry decides to enter a 1510/1550 bull call spread.  See below for the specifics on the options:

Purchase One July 1510 Gold Call Option for $3,700 (Pay)
Sell One July 1550 Gold Call Option for $2,100 (Collect)
Total Premium Paid for Position = $1,600 (3700 – 2100)

Larry’s maximum profit on the trade is the difference in the strike prices minus the total premium paid.

$4,000 Difference in futures price (40*100)
-1,600 Premium paid for call spread
$2,400 Maximum profit potential

Larry’s maximum risk is the $1,600 he paid to enter the spread.

This spread will realize maximum profit at expiration if the July gold futures market is trading at over 1550.0.  The options will be exercised, offsetting each other at the strike prices assigned to each option.  See below for how this would work at expiration:

  • July 1510 Gold call expires on June 27th, the option is exercised and Larry’s account is long a gold futures contract from 1510.
  • July 1550 Gold call expires on June 27th, assigning Larry’s account a short gold futures contract from 1550.
  • The long 1510 July Gold futures is immediately offset by the 1550 July Gold futures contract, allowing Larry to show a futures gain of $4,000 (40 * 100).
  • Larry’s realized profit is the gain in the spread offsetting by the cost of the spread, or $2,400.

Conclusion

As you can see, there are opportunities in the options market using the bull call scenario above.  It offers a great way to get involved in options at a desirable strike price with a limited risk.  You don’t have to wait until expiration to exit the spread.  You can exit any time you’d like to limit losses or collect profits before expiration.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Spreads, Strategies Tagged With: , , , , ,
April 25, 2011 by Leave a Comment

5 Tips for the Option Buyer

Tip 1:  Have an exit plan.

It seems very elementary, but some traders will spend numerous hours looking for opportunities to enter a market, but put no thought into how and when they are going to exit.  Whether you base your trading decisions technically or fundamentally, you will need to know when you are going to take profits and when you are going to cut your losses.  Just because you define your risk when purchasing options, this does not necessarily mean you have to risk it all.  Technical traders should look for the area on the chart that proves a change in the markets direction and a point on the chart to take your profit.  Fundamental traders should closely track the news that is driving the market and exit when these fundamentals change.  Just like you don’t jump in your car without a destination, you don’t want to jump into a trade without one.  Trading is emotional and your ability to articulate your trade parameters will only help your long term success as a trader.

Tip 2:  Buy the time you need.

The beauty of options is their flexibility.  Purchasing options allow for flexibility with the timing on your entry and the timing involved for the market to make its move.  That being said, we pay for that time and flexibility.  After all, the value of an option is derived from both its time value and its intrinsic value.  The more time on the option, the more we are going to pay for it.  So if we expect a market to rise or fall within the next few weeks, it does not make sense to buy an option that expires in 12 months.  On the flip side, if you are looking for an extended move in a market that could take place over several months, then you want to make sure you buy enough time to allow for that to happen.

Tip 3:  Don’t try to pick the tops and bottoms.

Don’t try to pick the tops and bottoms.  Like many things in life, markets will tend to follow the path of least resistance.  Just like a swimmer would prefer to swim with the current, a market prefers to follow its momentum.  From time to time, we might convince ourselves that a market can’t go any higher or lower, but we must resist this urge and stick to our trading plan.  Until there is a clear signal that the trend has ended, we must remain patient and wait for the reversal to be confirmed.  Anything outside of this is option roulette.

Tip 4:  Consider the market’s volatility.

An options premium is valued by its location relative to the underlying futures contract, the time left until expiration, and the market’s volatility.  As an option buyer, we want to purchase an option when volatility is low.  Increased volatility means that markets are going to trade in a much wider range.  That being said, options will be rapidly moving in and out of the money, causing a spike in the options premium.  Ideally, we will buy in times of low volatility to allow us to take advantage of the spike in premium if and when the volatility does increase.

Tip 5:  Consider your delta.

Your option’s delta should give you a good idea on how your option is going to react to a change in the underlying.  The lower the delta, the less the options value is going to fluctuate.  The higher the delta, the more closely your option will trade to the underlying futures contract.  An option’s delta will help you determine where you will want to be positioned based on the anticipated move.  For more on delta, please see my previous article:  Going Greek:  Understanding Your Option’s Delta.

Free Download:  Futures and Options Strategy Guide

If you enjoyed this article and are interested in learning more about futures options strategies, sign up for fast access to our Futures and Options Strategy Guide, detailing 21 futures options strategies that you can begin using in your trading today!

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Strategies Tagged With: , , ,
March 12, 2011 by 1 Comment

Going Greek:  Understanding your Option’s Delta

Option traders are often speaking another language.  I want to help you understand how your option’s value is going to be affected by changes in the market.  We can calculate how our option is going to react to these changes by understanding the Option Greeks.  The Black-Scholes Model identifies 5 Option Greeks to help us forecast the value of our option (Delta, Gamma, Vega, Theta, and Rho).  These Greek’s will help identify our option’s reaction to changes in the price of the underlying futures contract, time decay, volatility, and interest rate.  In this article we are going to explore the Delta.

Exploring Delta

Delta is the measure of the degree to which an option is going to move relative to the underlying futures contract.  In other words, it is a measurement tool to find out the speed the option value will change in relation to a full point move in the underlying futures contract.

For example let’s look at crude oil:

If my option has a delta of 0.50, this means that for every $1.00 move in the crude oil futures, my option will go up or down by $0.50 (1.00*0.5=0.50).  In other words, my option’s value will fluctuate approximately half the rate of the actual futures contract.  So if crude oil were to move $3.00, my option value would change by roughly $1.50.

The higher the delta, the more sensitive the option is going to be to the underlying futures contract.  The options distance from the current market price, as well as the number of days left until expiration are two factors that will determine the options delta.

Call Option Delta

For call options, the delta can range from 0 to 1.  A one delta would mean that the option is going to fluctuate tick for tick with the futures.  A zero delta would mean that the options value is not going to be affected by the movement in the underlying futures contract.  That being said, the deeper in-the-money an option is and the less amount of time the option has until expiration, the closer the delta is going to be to one.  The further out of the money and the more time an option has until expiration, the closer the delta is going to be to zero.  An at-the-money option will have a delta of around 0.50 because there is a 50% chance the option can move in-the-money, and a 50% chance the option can move out-the-money.

Put Option Delta

Put options, on the other hand, will have a negative delta, but the same rules apply.  Deep in-the-money puts will have a delta closer to -1, and far out-the-money options will have a delta closer to 0.  At-the-money puts will have a delta around -0.50.

Every trade begins with an idea.  Whether you are hedging or speculating in the markets, understanding your positions delta will give you a clearer picture on how your trade is going to react to price fluctuations.  Your delta, accompanied with the rest of the option Greek’s will help you more accurately forecast your options value and properly manage your position.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Risk, Strategies Tagged With: , , , , , , , , , , ,
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