by Matt Roma

If you aren’t trading options, you are missing out on a wide range of investment opportunities! Options on futures can offer you the ability to create a customized trading strategy based on your unique viewpoint of market price action, and can offer you the ability to define your risk. Options can give you more time to be right about the market’s direction too, without being stopped out of your position due to market volatility. Options are speculative investments, and should be treated as such. It is important to understand the basic concepts as well as the risks involved.

There are two styles of options: European and American. European-style options can only be exercised at expiration, while American-style options can be exercised at any time. The majority of exchange-traded options are American-style, so I will focus on those for the sake of this discussion. The concepts related to stock options are similar, but this article and the examples herein will focus on options on futures.

Option Definitions
An option gives the buyer the right, but not the obligation, to buy or sell a particular underlying futures contract at a stated price at any time prior to a specified date (known as expiration). You can see an example of the various expiration dates on the E-mini S&P 500 futures here.

A call option gives the investor the right, but not the obligation, to buy the underlying futures contract at a specified price within a specified date. You would buy a call if you have a bullish view of the underlying market. A put option gives the investor the right, but not the obligation, to sell the underlying futures contract at a specified price within a specified date. You would buy a put if you have a bearish view of the underlying market.

There are many more complex strategies involving options including strangles, straddles and butterflies with different objectives and risk profiles that are beyond the scope of this particular article.

The option’s strike price, also called the exercise price, is the fixed price at which the investor can purchase or sell the underlying futures contract. When a call option is “in-the-money,” that means it’s strike price is below the market price of the underlying asset, while a put option that’s in-the-money has a strike price above the underlying asset. A call option is “out-of-the-money” when its strike price is above the market, while a put option is out-of-the-money when its strike price is below the market. At-the-money options have strike prices equal to the underlying market’s price.

Option Valuation
An option’s value consists of two parts, the intrinsic value and the time value.

Intrinsic value represents the amount the option is “in-the-money.”  For example, if crude oil futures are trading at $84 a barrel and you have an $80 call, your call is in-the-money and its intrinsic value is $4. This option gives you the right to buy crude oil at a lower price than the prevailing market. If crude oil futures are trading at $75, then your call would have no intrinsic value. It would be out-of-the money. If the market remained at $75 on the expiration date of your option, it would be worthless and you’d lose what you paid for it and no more.

Conversely, if you had bought an $80 crude oil put and crude oil futures are trading at $75, then your put is in the-money with $5 of intrinsic value. At $85, your put is out of the money and would expire worthless if crude remained at $85.

Time value represents the portion of the price above intrinsic value. Time value is generally positively correlated to the time until expiration, because there is more time for the market to move and therefore more potential your option can finish in-the-money. For example, if it’s January and you buy a March option that is far out-of-the-money, there is less time for the market to move and therefore less likelihood it will be in-the-money by expiration than if you bought a December option.

Time value declines as expiration approaches. At expiration, time value is zero, and the only value of your option is its intrinsic value. As mentioned, the more volatile a market is, the more likely a particular option could be in-the-money at expiration and you are likely to pay a higher premium for it as a result. So in sum, the intrinsic value + time value = premium.

Leverage
You can actually gain more leverage in options than with futures trading, because often, your upfront cost is smaller when you trade options. This is a double-edged sword, as small changes in an underlying price of an asset can cause large percentage changes in the price of the option. Depending on your particular options strategy, that doesn’t necessarily mean you will lose more money, but it’s something to keep in mind.

If you trade options, you want to know where the underlying market needs to be priced for you to break even. To calculate your breakeven point, you look at the strike price, the premium, and commissions and/or other costs related to the trade. For example, If you were considering buying an $85 June crude oil call, the cost was listed at 90 cents, and your commission was $50, your breakeven would be 90 cents plus 5 cents to cover your commission cost. Adding that to the strike price, you need the market to be trading at $85.95 at expiration to recoup your costs. You turn a profit when crude oil is above that price.

How do you know which option you should purchase? You have two things to consider when choosing your option: the time to expiration and your strike price. One of the attractive features of an option is that you can allow yourself more time for your expectations to be realized. The length of the option is an important variable, as mentioned in the context of time value.

A call with a lower strike price will generally have a higher premium than an option with a higher strike price. That’s because you are buying the right to buy at a lower price, which is the ultimate goal of the bullish investor (buy low, sell high). Conversely, a put with a higher strike price will also be more expensive than a put with a lower strike price, as the bearish investor wants to do to the opposite. You also need to look at the price of the underlying futures, which can vary according to different contract months. If March corn futures are trading at $3.75 and July corn futures are trading at $4.10 and you are looking for March corn to move up in coming months, you wouldn’t want to buy a $4 July call because it is already in-the-money.

Risk Considerations
Buying an option allows you to define your risk to a specified amount, which many investors find attractive. You can calculate what your maximum loss would be if you are wrong in your opinion of the market. After you buy your (American-style) option, you can offset it anytime before expiration. You would simply sell it on the exchange for a profit if market has achieved your desired price, or for a loss if your opinion of the market has changed.

You can choose to hold your option until expiration if you think it will be in-the-money at that time. You can then sell it, or you can exercise your option to take a long position in the underlying futures contract. You can exercise prior to expiration, although most investors don’t do that because you’d be giving up the time value that’s priced in the option. It’s better to sell it instead. If you do hold an option until expiration and it is in-the-money, as mentioned, you will be delivered a futures contract and your risk profile changes.

When you buy an option, another individual is selling it to you. Selling options is known as options writing.  Options writing can be a compelling strategy for some investors, but is absolutely inappropriate for anyone who does not fully understand the nature and the extent of the risks involved.

Selling an option has the same risk profile as if you took a position in the underlying futures contract (potentially unlimited). While there are strategies to help control your risk, it’s possible that in a market where prices are changing rapidly, an option writer may have no ability to control the extent of his or her losses. Option writers should be sure to read and thoroughly understand the risk disclosure statement that is provided to them.

So why would anyone sell options then? An individual selling an option collects money for taking on that risk, which is the premium from the buyer. The options seller has the belief that the option is more likely to expire out-of-the-money than in-the-money. The option would expire worthless, and he pockets the premium and walks away. Of course, the buyer hopes for the opposite result.

I have only covered just a few of the concepts relating to options here. I encourage you to explore the topic further. Please feel free to call me with any questions you have about options, and the types of strategies that might be suitable for your unique situation.

Matt Roma is a Senior Market Strategist. He can be reached at 866-231-7811 or via email at mroma@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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