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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 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 19, 2011 by 1 Comment

Trading In Volatile Markets

This post originally appeared in FutureSource’s Fast Break Newsletter on May 17, 2011 where Craig Turner is a regular contributor on various futures trading topics.

Trading in volatile markets provides extraordinary opportunities but it also carries more risk.  For more aggressive traders, volatile markets can lead to larger than normal losses, but they can also provide rare opportunities that can be highly advantageous for your trading account.  If you are going to trade in volatile markets, or if you have positions and the markets become volatile, you need to know how to recognize the warning signs and navigate through the storm.  You have to be able to manage risk if you want to take advantage of substantial price moves.

1) Margins are Inadequate Guidelines in Volatile Markets

When a market is volatile, the first thing you should do is make sure the margin requirements are greater than the daily ranges in the market.  For example, when Silver was trading from $20 to $50, the exchange and clearing firms did not raise margins.  Anyone who has traded silver knows it can trade down 10% on its worst days.  In my opinion, margins should be at least a day’s trading range for any contract.  When Silver traded at $15 and $20, the biggest down days would be $1.50 to $2.00.  Margin for silver would be around $10,000 ($2.00 in the big contract).  This was appropriate for the contract.

Looking back, there was a big warning sign the Silver market could become a volatile market.  The red flag was the exchanges and clearing firms not raising margins as the Silver traded to $30 and then $40.  As the market climbed higher, the daily trading range was higher.  Margins stayed the same.  This meant that it was possible that too many traders were in the market without enough capital, which is always a recipe for volatility.

If you are trading a volatile bull or bear market, you need to use the possible daily trading ranges as a guideline for capital.  Exchanges and clearing firms are slow to act.  They are rarely ahead of the curve on margin issues, and they are usually caught off guard and have to increase margins after the damage is done.

By understanding that you need more capital on hand to trade volatile margins, you will have more staying power than the average trader.  The trader using margin as a guideline will not be able to stay in the position.  A trader who understands that volatile markets can have higher trading ranges than the exchange margin should be able to ride out the storm better.

2) De-leverage When the Markets Become Volatile

When the markets are volatile, it is not the time to double up.  If you are trading two contracts, it is the time to de-leverage and just trade one.  If you are trading one standard contract, it might be the time to shift gears and trade the mini contracts for a while.

When the markets become volatile, it doesn’t mean you have to stop trading.  Your opinion of the markets can still be correct but outside factors may be an issue.  For example, the US Dollar, European nations needing bailouts, wars in the Middle East, the natural disaster in Japan, can all affect the markets.  In my opinion, what you need to do is take on less risk during these times.  The only way to really achieve this is to de-leverage. The best way to do this is to reduce your position size so you can stay in the game.

3) Spreads May Help With Reducing Volatility

One possible way to hedge against volatility is to trade futures spreads.  Let’s say a trader has a long corn position in December 2011 corn.  The grain markets and commodity markets start to become volatile due to the US Dollar rallying because there are fresh concerns about the Euro and its member countries defaulting on their debt.  The soaring dollar is going to hurt the trader’s long Dec Corn position.

Let’s say the trader is very bullish on corn, understands the market could go down in the short term, and wants to stay in his position for the medium to long term.  Using the spread methodology, the trader would then short a different month in Corn to attempt to protect himself.  In this case, the trader would most likely short July 2011 Corn or Dec 2012 Corn.  Either way the trader can now better ride out the storm until the volatility passes.  Once the trader is confident again that corn will start moving higher, he just lifts the short corn leg of the spread and leaves the long Dec 2011 Corn position on.

What is nice about this option is the margin the trader was using for long 1 contract of corn (over $2000) is now about $500 for the spread.  Not only is the trader potentially reducing risk, he is also reducing margin requirements.  The trader does not have to come up with more capital to short an extra contract.  Because, on average, futures spreads reduce risk when compared to outright positions, the exchanges recognize this and require less margin.

4) Options Offer Protection on Existing Futures Positions

There are two ways to use options in volatile markets.

For those trading futures, you can use options to hedge against short term volatility.  Let’s say you are long December Corn and you think the market could sell off 20 to 30 cents before rallying a full dollar.  The trader can keep the Corn position on and also buy a December Corn put.  If the market really does sell off 20 to 30 cents, the trader can liquidate the option for a profit and then hold Corn as he looks for the bottom to come and the rally to start.

The second way to use options is to not trade futures during times of volatility and just use Option Spreads.  Let’s say you are bullish December Corn, you think the markets are going to be volatile, but you want a bullish position.  By using a bull call spread in December Corn, the trader has a defined risk and reward, and the short term volatility should not change the value of the spread nearly as much as a futures contract or just being long a single call option.

5) Summary

When the markets become volatile, traders need to have more capital for their positions.  Greater daily trading ranges means traders should have more capital per position.  If the trader does not have the capital for the increased volatility, they need to de-leverage.  One way to de-leverage is to either reduce position size or trade mini contracts instead of standard contracts.

Another way to de-leverage is to use futures spreads.  Traders caught in a volatile market can use futures spreads to potentially reduce the risk in their position.  They can leg out of the spread into their original position after the smoke has cleared.  Finally, traders can also reduce risk and de-leverage by using options with their futures position or just use option spreads, like a bull call spread or a bear put spread.

All in all, the most important thing to take away is that when the markets are volatile, traders need to reduce their risk exposure.  While volatility may provide extraordinary profit potential, it also may lead to greater than normal risk.  Traders need to manage this risk while still being able to take advantage of price movements in the market.  By reducing their risk exposure, traders will be able to stay in the game and have the opportunity to go after substantial price moves.

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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: Risk, 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: , , , , ,
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: , , , , , , , , , , ,
December 30, 2010 by Leave a Comment

How to Collect Premium with Iron Condors

How to Collect Option Premium with the Iron Condor Strategy

Different circumstances call for different trading strategies.  Part of becoming a complete trader is a balanced, disciplined approach with an eye geared towards managing risk.  You can accomplish this by trading futures, options, or a combination of the two.  The difficult part is determining which approach will be the best for you, and this formula might be different for every trader.  In this article, my intention is to open your eyes to a more unique trading approach, collecting premium with Iron Condors.

I’ve heard a lot of myths and confusion in regard to iron condors, so I’m attempting to break this down for you in simple, easy to understand language.  In order to accomplish this, we need to have a basic understanding of credit spreads.

Understanding Credit Spreads

A credit spread is when you sell a closer to the money (more expensive option) and purchase a cheaper (further out of the money option) on the same underlying commodity at the same expiration.

Let’s take a look at an example using gold futures;

Gold futures    =    1400
1350 puts    =    $3500
1300 puts    =    $1500

Gold futures are trading at 1400 and we feel bullish on this market.  We could sell a 1350 put and purchase a 1300 put.  The premium in the 1350 put is going to be higher than the 1300 put because it is closer to where the market is currently trading.  We would collect the $3500 premium from the 1350 put and pay out the $1500 premium of the 1300 put at a net credit on the trade of $2000.  Our defined profit is the amount we collected between the 1350/1300 put spread, $3500 – $1500 = $2000.  We’re risking the difference between our two strike prices, (1350 – 1300 = 50 x $100/point = $5000.  And, since we already collected a premium of $2000, our defined risk is reduced to $3000 ($5000 – $2000 = $3000).

So… What is an Iron Condor?

An Iron Condor is simply a combination or two vertical spreads.  To create the iron condor, we would sell both a call spread and a put spread.  The idea behind this is to take advantage of a sideways market and allow us to design a strategy based on where we feel the market will NOT go.

How to Use an Iron Condor Strategy

Once again, let’s take a look at an example using gold futures.

The current price of gold is 1400.  We feel that the market will likely trade within a channel between 1350 and 1500 over the next 30-60 days.  Gold options are currently trading at the following prices:

1500 call    =    $3500
1550 call    =    $1500
1350 put    =    $3500
1300 put    =    $1500

In order to take advantage of a sideways market we would use an iron condor by selling the 1500/1550 call spread and the 1350/1300 put spread.

How to Calculate the Profit Potential

Profit/loss graph for a long Iron Condor at expiration.

We would place an order to sell the 1500 call and purchase the 1550 call.  We would collect $2000 premium on our call spread ($3500 – $1500 = $2000).  We would also sell the 1350 put and purchase the 1300 put.  We would collect another $2000 premium on our put spread ($3500 – $1500 = $2000).  This would define our profit potential to $4000 (total premium from call spread + put spread, $2000 + $2000 = $4000).

Maximum Profit Potential = Call Spread Premium + Put Spread Premium

How to Calculate the Defined Risk

We can also use these numbers to calculate our defined risk.  Our defined risk is the difference between our spread strike prices minus the amount we collected.  Since we have both a put and call spread, we know our risk is limited to only one side.  The market cannot expire above our call spread and below our put spread simultaneously, so we have a risk of just $5000 (1350 – 1300 = 50 x $100/point = $5000 or 1500 – 1550 = 50 x $100/point = $5000).  Note: If the difference between our strike prices were not balanced, we would use the greater difference.  However, this is before we take into account the premium we collected.  We have collected a total of $4000 for our put and call spreads upfront, so we can deduct this from our risk total.  Thus, our defined risk would be reduced to $1000 ($5000 – $4000 = $1000).

Defined Risk = Greater Difference between Strike Prices – Premium Collected

Benefits of an Iron Condor Trading Strategy

Now that we understand what an Iron Condor is, we need to understand why we would want to use this trading strategy.  Buying options are great in regard to their risk reward.  You can define your risk to a very small sum, while having unlimited profit potential.  The downside of this strategy is the probability.  The majority of cheap, far out of the money options will expire worthless.  So although you are only risking a few hundred dollars on each option, the odds of these being profitable are low. 

That being said, if the majority of options are going to expire worthless, then why don’t we just sell options? You can, but you are running the risk of that one cheap option turning into a very valuable option.  So you might have a defined profit a few hundred dollars with unlimited risk.

This is why the Iron Condor is an attractive strategy.  You are doing your part managing your risk because you know what the worst outcome can be.  You are also keeping the odds in your favor.  We know that the majority of all out of the money options are going to expire worthless, so we should have more profitable trades than losing trades.

In conclusion, an Iron Condor can be a simple strategy.  It is a combination of two credit spreads: one to the call side and one to the put side.  This allows you to take advantage of sideways markets and to design a strategy based on where you feel the market will NOT go.  This strategy allows you to define your risk, while keeping the odds in your favor, and providing you with a flexible and disciplined approach to the markets.

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!

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: , , , , , , , , ,
December 17, 2010 by 1 Comment

Options on Futures:  An Introduction to Buying Options

This post originally appeared in FutureSource’s Fast Break Newsletter, where Drew Wilkins is a regular contributor on various futures trading topics.

One of the most common questions a futures broker gets is, “How do options on futures work?”  The truth is, options can be as simple or complex as you want them to be.  This article will focus on the basics of buying options on futures, basically starting from scratch.

There are two types of options, calls and puts.  The options can either be bought or sold.  We will only focus on buying options in this article.  Buying a call gives you the right to take a long position on the underlying futures contract.  Buying a put gives you the right to take a short position on the underlying futures contract.  Simply stated, when you think the market will go up, buy a call.  When you think the market will go down, buy a put.

Understanding the Strike Price

When purchasing a call or put, you will be doing so on an underlying futures contract (e.g. corn futues, gold futures, crude oil futures, etc.).  The price at which you purchase the option is called the strike price.  Options differ from futures in that you can purchase options at a variety of strike prices, whether the underlying market trades at the price or not.  When purchasing the option, you can either purchase strikes that are out of the money, at the money, or in the money.

  • Out of the Money Options – Out of the money call (put) options involve strike prices that are purchased above (below) where the underlying market is currently trading.
  • At the Money Options – At the money call and put options are strike prices that are purchased where the underlying market is currently trading.
  • In the Money Options – In the money call (put) options are strike prices that are purchased below (above) where the underlying market is currently trading.

See the following screenshot for February Gold taken from our Vantage trading platform.  Register for a complimentary demo of Vantage.

Feb Gold Chart

Click to View Larger February Gold Chart

This image is focused on calls.  The darker blue line going across the 1390 option is currently at the money.  The options from 1385 to 1350 are currently in the money, and the options from 1395 to 1450 are out of the money.  There are three columns you want to focus on.  They are the bid, ask, and last columns.  The bid shows you what someone is looking to pay to purchase a call.  The ask shows you how much money someone is willing to accept to sell the call, and last shows you what price the last trade took place.  The more in the money the call (from 1385 to 1350), the more expensive it becomes.  The further out of the money the call is (from 1395 to 1450), the cheaper it becomes.

Exercising a Purchased Option

Once a trader decides on a strike price and purchases a gold call, he will have the right to take a long position in the underlying gold futures market at the strike price purchased.  If the trader chooses to use this right, he will have to exercise the option.  Exercising the option is converting the call option to a long futures position at the strike price purchased.  For example, the trader purchased a February 2011 1400 gold call with hopes that the market would continue in an upward trend.  After a month of owning the option, the market is trading at 1435.  The trader decides that he would like to exercise the option and be assigned a futures position at 1400.  The trader will show a futures position with a profit of $3500 (100 (value per $1 gain in a gold futures contract) * (1435-1400)).  However, the entire premium gained in the option is not transferred to the futures position.  Why would the trader have exercised the position when it appears the position would have been more profitable as an option?  There are two reasons:  intrinsic value and time value.

Understanding Intrinsic Value and Time Value

An option is a wasting asset.  Options, like futures contracts, have expirations.  They tend to expire one month before the underlying futures contract.  Intrinsic value and time value, make up an options premium or worth.  Intrinsic value is the amount that would be credited to the traders account if the option was exercised and the subsequent long futures position is immediately sold at the market price.  In our example above, the trader has a 1400 call with the underlying market trading at 1435.  The intrinsic value of the option is $3500 (100 * (1435-1400)).  An option will only have intrinsic value if it is in the money.  Time value is what is left of the options premium.  The further away an option is from its expiration, the more time value it will have.  If the 1400 call has a premium of $5700, then the time value of the option is $2200 (5700-3500).  The intrinsic value and time value must always add up to equal the options premium.  As mentioned before, an option is a wasting asset.  The closer the option gets to expiration, the more the time value will decrease.  If the trader in the example above purchased the option on December 15th and exercised the position a month later, there would be very little time value still associated with the option.  Since the trader knew that he would have an extra month for the futures contract to potentially increase, he chose to exercise the option.

Offsetting an Option Position

A trader doesn’t always have to exercise an option.  In fact, most don’t.  Another way to get out of an option position is to offset the option.  Offsetting an option simply involves selling the option that you purchased.  For example, if you purchased a February 2011 1400 gold call, you can offset the call by simply selling it.  If the option still has time value, this is the way that you can capture it and make it more profitable.  In the example above, if the underlying gold price stays at 1435 and the trader holds the option to expiration, the option will be exercised and the trader will then hold a long futures position worth $3500.  If the trader thinks the price of the underlying will stay the same, he can offset the position by selling the call he purchased for $5700, capturing the remaining time value.

Another Example in the Gold Market

Now that the basics of buying options on futures have been covered, let’s take a look at another example.  A trader wants to get into a February 2011 gold option.  He thinks that the market is going to continue on its current upward trend, so he wants to purchase a call.  Keeping his account value in mind, the trader decides he is willing to spend $2500 on an option.  After looking at the image above with strike prices, he decides to place an order to buy a February 2011 1405 gold call.  He purchases the call option for $2500.  Knowing that an option is a depreciating asset, he closely monitors gold prices while he is in the position.  The trader is correct and the underlying gold contract increases to 1430 within two weeks.  The trader now thinks that the underlying gold contract is going to remain at its current level or decrease until his option expires.  The current value of his option is now $3700.  The trader knows that the intrinsic value is $2500 ((1430-1405) * 100).  He also knows that the time value on the option is $1200 (3700-2500).  Since he thinks that the underlying price will remain the same or decrease, he decides to offset the position to capture the additional time value in the option.  The trader ends up with a profit of $1200 (Premium of option when offset (3700) – premium when initially purchased (2500).

Options on futures don’t have to be the mountain that most make them out to be.  Simply learn the basics and increase your knowledge as you progress in your trading.  Before you know it, the mountain will become a molehill and you will have the knowledge to use options in your everyday futures trading.

Expand Your Futures Trading with Options on Futures

If you enjoyed this article and want to learn more about options on futures, please dowload our Options Trading Starter Kit.

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: Getting Started, Options, Strategies Tagged With: , ,
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