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Options On Futures Contracts A Guide To Their Uses and Risk Options on futures contracts are a relatively new and increasingly popular type of investment. They have been competitively traded on regulated futures exchanges only since the early 1980s. Yet they now account for a significant portion of the total volume of futures trading. The principal attraction of options - known as call and put options - is that they offer a option buyer the potential for substantial profit while limiting the option buyer’s risk to the up-front cost of the options (known as the "premium") plus the commissions and other transaction cost to do the trade. Despite the pre-defined risks for the buyer, options are not an appropriate investment for many people. The fact that you can, and may, lose your entire investment. Indeed, options should be regarded as a highly speculative investment. This doesn’t mean you should not consider options as an investment; some people have realized large profits by purchasing options when significant price movements are correctly anticipated. Moreover, it’s possible that gains realized on even a few profitable options could more than make up for losses incurred on other, unprofitable options. As with any type of investment, it’s important to be certain your decision is an informed decision. One of the best all-purpose investment rules anyone can follow is: NEVER INVEST YOUR MONEY UNLESS YOUR UNDERSTANDING OF THE RISKS IS AS GOOD AS YOUR UNDERSTANDING OF THE OPPORTUNITIES. This article has been prepared to provide an introduction to options on futures contracts, how they work and the opportunities and risk associated with their purchase. It consists of four parts: Part One: A Pre-Investment Quiz for Options Buyers.
Part Two: The Vocabulary of Options Trading.
Part Three: The Arithmetic of Options Opportunities and Risk.
Part Four: Do’s and Don’ts - A Final Checklist.
Part One: A Pre-Investment Quiz for Options Buyers
If your answer was "NO" to any of these questions, that should probably be a signal that you need to ask some questions of your own before making a decision to invest. In some instances, this section may be helpful in providing answers. In other cases, you might ask the broker to clear up points about which you’re uncertain. And in still other situations, a trusted financial advisor or a regulatory organization such as the Commodity Futures Trading Commission or National Futures Association could be the appropriate place to address your questions. Part Two: The Vocabulary of Options Trading Below are some of the major terms you should become familiar with, starting with what is meant by an "option".
Part Three: The Arithmetic of Option Trading along with the Opportunities and Risks Put and call options are traded on a wide range of futures contracts encompassing agricultural commodities, financial instruments such as U.S. Treasury securities, foreign currencies, metals, petroleum products, and stock indices. For the individual who has a price opinion (that a particular futures price will change by at least some given amount in a certain direction within a specific period of time), buying options offers the opportunity to realize substantial profits with a predefined and limited risk. The maximum an option buyer can lose - should events prove him wrong about the direction, extent or timing of the price change - is the premium paid for the option plus commissions and other transaction cost. The fact that an option buyer’s potential loss is limited does not necessarily mean a loss is unlikely. Buying options is a speculative investment and many options expire without becoming profitable. In this case the holder of an option would lose his entire investment including transaction costs. THE FIRST STEP: Calculating the Break-Even Price Before purchasing any option, it’s essential to precisely determine what the underlying futures price must be for that particular option to break-even or become profitable if it is exercised. Without this information, there is no way you can make an intelligent decision about whether to buy the option. The calculation isn’t difficult. There are only three things you need to know to figure a given option’s break-even point:
Determining the Break-Even Price for a CALL Option Option Strike Price + Option Premium + Commission & Transaction Cost = Break-Even Price EXAMPLE: It’s now January and the April Crude Oil Contract (1000 Barrels) is currently trading at around $17.50 a barrel. You expect that over the next several months there may be a significant price increase. That is, you believe the April Crude Oil futures price will rise significantly above its present level. To profit if you are right, you are considering buying a call option with a strike price of, say, $18.00 a barrel. Assume that the premium for that option is $.95 a barrel (a total of $950.00 for the 1,000 barrel option) and that the commission and other transaction cost will be $50.00, which amounts to $.05 a barrel. Before investing, you need to know exactly how far the April Crude Oil Futures price must increase prior to the expiration of the option in order for the option to break-even or yield a net profit after expenses.
Option Strike Price ($18) + Premium ($95) + Commission & Transaction Cost ($.05) = Break-Even Price ($19) The option will exactly break-even if the April Crude Oil futures price when the option is exercised is $19.00 a barrel. For each $1.00 a barrel the price is above $19.00, the option will yield a profit of $1000.00. At a price below $19.00, there will be a loss. But in no case can the loss exceed the $1000.00 total of the premium, commission, and transaction costs. Determining the Break-Even Price for a PUT Option The arithmetic is the same as for a call except that instead of adding the premium and transaction costs to the option strike price, you subtract them. Option Strike Price - Option Premium - Commission & Transaction Cost = Break-Even Price EXAMPLE: The price of gold is currently just above $370 an ounce, but during the next few months you expect a sharp decline. To profit from the price decrease if it occurs, you are considering the purchase of a PUT option with a strike price of $370.00 an ounce. The option would give you the right to sell a specified Gold Futures Contract (100-Ounce) at a $370.00 an ounce price at any time prior to the expiration of the option. Assume the premium for this particular option is $11.40 an ounce (a total of $1,140) and that the commission and transaction costs are $50.00 (equal to $.50 an ounce). For the option to break-even or yield a profit when exercised, the futures price must be $358.10 or lower, determined as follows: Option Strike Price ($370) + Premium ($11.40) + Commission & Transaction Cost ($.50) = Break-Even Price ($358.10) The option will exactly break-even if the futures price is $358.10 when the option is exercised. For each $1.00 an ounce the futures price is below $358.10, it will yield a profit of $100.00. If the futures price is above $358.10, there will be a loss. But in no case can the loss exceed $1,190.00 - the sum of the premium ($1,140.00) plus the commission and other transaction costs ($50.00). Choosing Which Option to Buy If you expect a price increase, you’ll want to consider buying a call option. If you expect a price decrease, you’ll want to consider buying a put option. But that’s only the first decision you will need to make. You’ll also need to decide on:
THE LENGTH OF THE OPTION One of the attractive features of options is that they provide time for your price expectations to be realized. The more time you allow, the greater the likelihood the option will eventually become profitable. This could influence your decision about whether to buy, say, an option or a June futures contract. Bear in mind that the length of an option (such as whether it has three months to expiration or six months) is an important variable affecting the cost of the option. All else being the same, a longer option commands a higher premium. THE OPTION STRIKE PRICE At any given time, there may be trading in options with half a dozen or more different strike prices. Some of them below the current price of the futures contract and some of them above. Example: At a time when the July Soybean futures contract is quoted at, say, $6.00 a bushel, Put and Call Options may be offered with strike prices of $5.50, $5.75, $6.00, $6.25, $6.50, and $6.75. The relationship between the strike price of an option and the current price of the underlying futures contract is, along with the length of the option, a major factor affecting the option premium. All else being the same, a call option with a low strike price will have a higher premium cost than a call option with a high strike, because it will more likely and more quickly become worthwhile to exercise. Example: The right to buy soybeans at $5.75 a bushel is more valuable than the right to buy soybeans at $6.00 a bushel. Conversely, a Put Option with a high strike price will cost more to purchase than a Put Option with a lower strike price. Example: The right to sell Soybeans at $6.00 a bushel is more valuable than the right to sell soybeans at $5.75 a bushel. HOW TO DECIDE An option with a short time to expiration or an option that requires a substantial price change in order to become profitable will be less expensive to purchase because of its lower premium cost. Consequently, if the anticipated price change fails to occur during the life of the option, your loss will be less. But such an option may have relatively little likelihood of becoming profitable prior to its expiration. On the other hand, paying a higher premium for an option with more time to expiration or with a more favorable strike price will increase the amount of money you have at risk and thus the size of your potential loss. Choosing which, if any, option to buy therefore demands careful figuring. At the very least, use the formulas described early in this article to calculate the Break-Even point for several different option alternatives, options with different strike prices and different lengths of time remaining to expiration. The final decision will ultimately come down to such considerations as your own analysis of the commodity’s price outlook, comparative premium costs, and how large an investment you are willing and able to risk. Options investments should be made with the same care and caution as any other investment, but with special attention to the risk that purchasing and unprofitable option could result in the loss of your total investment. After You BUY an Option, What Then? At any time prior to the expiration of an option, you can:
EXERCISING AN OPTION As the buyer of an option, you can exercise the option at any time of your choosing prior to the expiration of the option. It does not have to be held until expiration. It is essential to understand, however, that exercising an option on a futures contract means that you will acquire either a long or short position in the underlying futures contract, a Long Futures Position if you exercise a Call Option and a Short Futures Position if you exercise a Put Option. Example: You’ve bought a Call Option with a strike price of $.70 a pound on a 40,000 pound Live Cattle Futures contract. The futures price has risen, to say, $.75 a pound. Were you to exercise the option, you would acquire a Long Cattle Futures Position at $.70 with a "paper gain" of $.05 a pound ($2,000). And if the futures price were to continue to climb, so would your gain. But there are both costs and significant risks involved in acquiring a position in the futures market. For one thing, the broker will require a cash margin deposit to provide protection against possible fluctuations in the futures price. And if the futures price moves adversely to your position, you could be called upon, as often as daily, to make additional cash margin deposits. Secondly, unlike buying a Call or Put Option which has limited risk, a futures position has potentially unlimited risk. The further the futures price moves against your position, the larger your loss. Even if you were to exercise an option with the intention of promptly liquidating the futures position acquired through exercise, there’s the risk that the futures price which existed at the moment may no longer be available by the time you are able to liquidate the futures position. Futures prices can and often do change rapidly. Example: You have a Cattle Call Option with a strike price of $.70 a pound. The futures price has now risen to $.75 and you instruct your broker to exercise the option and promptly liquidate the position at a futures price of $.75. The risk is that by the time the position can be liquidated, the futures price may no longer be $.75 a pound. It may be substantially less than that. For all these reasons, only a small percentage of option buyers elect to realize option trading profits by exercising an option. Most choose the alternative of having the broker offset - i.e., liquidate - the option at its currently quoted premium valve. OFFSETTING AN OPTION As indicated, liquidating an option in the same marketplace where it was bought is the more frequent method of realizing option profits. Liquidating an option prior to its expiration for whatever value it may still have is also a way to reduce your loss (by recovering a portion of your investment) in case the futures price hasn’t performed as you expected it would, or if the price outlook has changed. In active markets, there are usually other investors who are willing to pay for the rights your option conveys. How much they are willing to pay (it may be more or less than you paid) will depend primarily on:
Net profit or loss, after allowance for commission charges and other transaction costs, will be the difference between the premium you paid to buy the option and the premium you receive when you liquidate the option. Example: In anticipation of rising sugar prices, you bought a call option on a sugar futures contract. The premium cost was $950.00 and the commission and transaction costs were $50.00. Sugar prices have subsequently risen and the option now commands a premium of $2500.00. By liquidating the option at this price, your net gain is $1500.00. That’s the selling price of $2500.00 minus the $950.00 premium paid for the option minus $50.00 in commission and transaction cost.
Buyers of options should be aware, however, that there is no guarantee that there will actually be an active market for the option at the time you decide you want to liquidate it. If an option is too far removed from being worthwhile to exercise and/or if there is too little time remaining until expiration, there may not be a market for the option at any price. Assuming, though, that there’s still an active market, the price you get when you liquidate will depend on the option’s premium at that time. Premiums are arrived at through open competition between buyers and sellers on the trading floor of the exchange. CONTINUE TO HOLD THE OPTION As previously indicated, you as the buyer (holder) of the option have the right to decide when you want to exercise or liquidate the option rights. The timing of exercise or liquidation is entirely up to you. In fact, the right to continue to hold an option right up to the final date for exercising or liquidating it is one of the features that makes options attractive for some investors. It means that even if the price change you’ve anticipated doesn’t occur as soon as you expected - or even if the price initially moves in the opposite direction - you have the assurance of knowing that the most you can lose by continuing to hold the option is the sum of the premium and transaction costs. Eventually, at some point prior to expiration, a change in the underlying futures price may make the option profitable. This is why it’s sometimes said option buyers have the advantage of staying power. You should be aware, however, that all else being equal, options decline in value as they approach expiration. (See "Time Value") THE ARITHMETIC OF OPTION PREMIUMS At the time you purchase a particular option, its premium cost may be, say, $1000.00. A month or so later, the same option may be worth only $200.00 or $300.00 or $400.00. Or it could be worth $2000.00 or $3000.00 or $4000.00. Since an option is something that most people buy with the intention of eventually liquidating (hopefully at a higher price), it’s important to have at least a basic understanding of the major factors which influence the premium for a particular option at a particular time. There are two, known as intrinsic value and time value. The premium is the sum of these. Premium = Intrinsic Value + Time
Value INTRINSIC VALUE Intrinsic value is the amount of money, if any, that could currently be realized by exercising the option at its strike price and liquidating the acquired futures position at the present price of the futures contract. Example: At a time when a US Treasury Bond futures contract is trading at a price of 108-00 ($108,000), a Call Option conveying the right to purchase the futures contract at a below-the-market strike price of 103-00 ($103,000) would have an intrinsic value of $5000.00. An option that currently has intrinsic value is said to be "in-the-money" (by the amount of its intrinsic value). An option that does not currently have intrinsic value is said to be "out-of-the-money." Example: At a time when a US Treasury Bond futures contract is trading at a price of 108-00 ($108,000), a Call Option with a strike price of 103-00 ($103,000) will be "in-the-money" by its intrinsic value of $5000.00. On the other hand, if the strike price of the call was, say 111-00 ($111,000), the option would be "out-of-the-money" by $3000.00. TIME VALUE Options also have time value. In fact, if a given option has no intrinsic value - because it is currently "out-of-the-money" - its premium will consist entirely of time value. What’s "TIME VALUE?" It’s the sum of money option buyers are presently willing to pay (and option sellers are willing to accept) for the specific rights that a given option conveys. It reflects, in effect, a consensus opinion as to the likelihood of the option’s increasing in value prior to its expiration. The three principal factors that affect an option’s time value are:
WHO WRITES OPTIONS AND WHY Up to now, this booklet has talked only about buying options. But is stands to reason that when someone buys an option someone else sells it. In any given transaction, the seller may be someone who previously bought an option and is now liquidating it. Or the seller may be an individual who is participating in the type of investment activity known as option writing. The attraction of option writing to some investors is the opportunity to receive the premium that the option buyer pays. This can be a profitable activity but it is also an extremely high risk activity.
The amount of the option writer’s loss could substantially exceed the amount of the premium income he received from writing the option. RISK CAUTION: Option writing as an investment is absolutely inappropriate for anyone who does not fully understand the nature and extent of the risks involved and who cannot afford the possibility of potentially unlimited losses. It is also possible in a market where prices are changing rapidly that an option writer may have no ability to control the extent of his losses. The same Risk Disclosure Statement for Futures and Options that is required to be provided to buyers of options also describes the significant risks inherent in writing options. COMMISSION CHARGES Each firm is free to set its own commission charges but these must be fully disclosed in a manner that is not misleading. In considering an option investment, you should be aware that:
The level of the commission charge may not, of course, be the only factor to consider. Different firms may offer different services and, if you rely on a broker’s guidance in selecting options to purchase, the quality of the advice should also be a consideration. Part Four:Do’s and Don’ts - a Final ChecklistDO take the time and effort to check out any firm or individual that you don’t know through previous experience or reputation. All firms and persons offering options on U.S. futures contracts are required by law to be registered with the (CFTC) Commodity Futures Trading Commission and to be Members of the (NFA) National Futures Association. A toll-free phone call to the NFA at 1-800-621-3570 or 1-800-572-9400 in Illinois can determine whether these requirements are being met and whether the person or firm has been the subject of any NFA disciplinary actions. The NFA is a Congressionally authorized self-regulatory organization of the futures industry and is entirely financed by the futures industry. No person or firm may engage in any business which involves buying or selling futures contracts for the public without being an NFA Member. The purpose of the NFA is to assure high standards of business conduct by its Members and to protect the public interest. DO inquire as to what the firm’s commission charges will be. DO calculate exactly the Break-Even price for any option you are considering: that is, how much the underlying futures price must increase or decrease during the life of the option in order for the option to become profitable. DO read and fully understand the required Risk Disclosure Statement for Futures and Options before making and commitment to purchase an option. DO be certain you understand the risks inherent in acquiring a futures position through the exercise of an option. DO learn enough about the commodity you would be investing in to have a reasonable expectation that the necessary price change may occur prior to the expiration of the option. DON’T make any investment - options or any other type of investment - on the basis of high-pressure sales tactics. Reputable firms don’t operate that way. It’s far better to miss out on an investment opportunity than to be rushed into a decision you may later regret. DON’T purchase options unless you understand that, once an option expires without becoming worthwhile to exercise, you will lose your entire investment. DON’T purchase any option that is presented to you as a sure thing. There aren’t any sure things! DON’T hesitate to seek the advise of other persons such as a knowledgeable financial advisor, attorney or accountant before making a major investment decision. DON’T invest any money unless the money can be legitimately regarded as risk capital. |