If you are looking to buy high-end exercise equipment, you would research and analyze its features and technologies before making a purchase. After all, you will want to see some improvement in your fitness levels after such a big outlay of cash.
It’s the same thing with investing, especially when it comes to more complex instruments such as options on futures contracts. You are striving for a decent return on your money, but that’s unlikely to happen unless you understand all the moving parts in futures options.
The Basics
The first thing to know about futures options is that the instrument grants you the right to buy or sell a futures contract any time before the option expires. But unlike a futures contract, it’s not an obligation.
The main components of options are: the current price of the underlying futures contract, strike price, expiration date and premium. Once you have grasped these main elements, you will be on your way to determining the value of an option.
Also, be aware of the difference between Call and Put options. A Call option allows you to buy a futures contract at a certain “strike price” while a Put allows you to sell at a defined price.
An Example
Okay, let’s imagine you are optimistic about the future of gold, but don’t want to buy the commodity outright, or put up a lot of money for a futures contract. Instead, you can invest in a call option on gold for a fraction of the price.
So, you buy a November gold option with a strike — or exercise — price of $1,500 for a $10 premium. Because each option is comprised of 100 ounces of gold, your initial outlay will be $1,000. The option is for the underlying gold futures contract, but that is not your objective here.
The real plan is to sell the option, for a profit, before the expiry date. You don’t need to wait for the gold futures price to rise to your strike price of $1,500 because your option will gain in value if the underlying asset price rises.
As an example, you bought the November $1,500 gold call in September. At that time, gold futures were trading at $1,400. But one day, gold jumps $20 an ounce, to $1,420. Guess what? Your option would also increase in value.
Your option could now be worth $11, representing a paper profit of $100. Why is that? Because the market sees the option marching higher towards the strike price. You could sell the option that day or any day when you turn a little bearish on the commodity. It’s up to you decide when you think it’s time to liquidate.
Now obviously if you bet wrong and gold falls your option value begins to decline, putting at risk your initial $1,000 investment. But that is the limit of your risk. You could also still sell the slumping option, meaning you would get some of the money back, thereby limiting your loss.
As you can see, futures options, like exercise equipment, come with somewhat complex components. Interestingly, the underlying value of the futures contract is key, and that will still be driven by market fundamentals.
With options, you are looking down the road and trying to assess the value of the underlying asset. Looking at it another way, options are like muscles — they atrophy over time, so sooner or later you must decide whether to sell that option at the most opportune time for you.
