magic words and you will never getlost in an option maze.21
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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An option is simply a contract, just like a futures contract.There is a buyer and a seller. Money is exchanged to obtain certainrights, and money is accepted to assume certain responsibilities.The time frame and price are set, as are the details of what is to besold or bought.Think in terms of a real estate transaction. You want to buy a10,000-square-foot parcel of land in a shopping center. But you donot have your financing in place, nor do you have approval for thebuilding you wish to construct. You really believe the location ofthe parcel is perfect for what you want to build, but you need time.What do you do? You go to the owner—or have your realestate broker do it for you—and see if he or she will give you anoption on the land. You want three months and are willing to givethe owner 5 percent of the asking price. Additionally, if you exercise the option, you agree to pay the owner a specified sum thatyou mutually agree upon in advance.You have now locked up the property for three months; noone but you can buy it during that period of time. In return, youhave paid the owner a premium to hold the property for you. Iffor some reason you change your mind and can’t get the building you want approved or the financing, you can walk awayfrom the option to buy the land. You lose your premium, but thatis all. Or, if everything works out as planned, you exercise youroption and buy the land. You might even negotiate a clauseallowing you to assign the option contract to a third party beforethe expiration date.Now, if you were the owner of the land, you would be thegrantor of the option. You would receive the premium. You wouldhave the obligation of holding the land off the market for threemonths and delivering it to the owner of the option at the predetermined price. If the buyer of the option did not exercise theoption at the end of the term of the option, you would keep theoption payment or premium and put the land, which could bereferred to as the underlying entity, back on the market. The optionhas expired.This is what is known as an over-the-counter option (OTC).All the terms are negotiated between the buyer and seller. Optionson-futures, like futures contracts, are exchange traded. The clearingfirm sets all the terms, except price and quantity. The buyer and
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seller decide how many options to buy or sell and arrive at a pricevia an open outcry auction in the trading pits at the exchange.Naturally, you access the exchange through a commodity broker.Exchange-traded options offer one advantage not generallyavailable to the OTC option buyers or sellers—the ability to tradethe option. Conceivably, an OTC option can be sold or traded to athird party, but it is the obligation of the buyer or seller to find thatthird party. With exchange-traded options, there is usually a buyeror seller immediately available. The key word here is usually. Attimes and under certain market conditions, you can have a problem finding a buyer for an option, but you will almost always finda seller. All this will make more sense shortly, but it is important tolearn why there is a difference.Another advantage of exchange-traded options is that youcan play the short side of the market as easily as the long. Try goingup to a land owner and telling him or her you think the propertyin question is going to lose 20 percent of its value and you wouldlike to buy an option to buy it at a substantial discount to theappraised value. You would probably be thrown out on your ear!Now let’s begin defining specific terms of an option transaction. When you pay for the right to buy a long position in an underlying entity, in this case a futures contract, the option is referred to asa call option. A call gives you the right, but not the obligation, to takea long position in a specific futures contract. Since you want to belong, you must be bullish and believe the underlying entity is goingup in value.When you acquire the right to a short position in a futurescontract, you buy a put. You are bearish regarding the prospects forthat futures contract. You think it is heading south (see Table 2-1).Now you must select a price at which you will decide to exertyour right. This is called the strike price. The options committee onthe exchange on which the options are traded sets the strike prices.They are set at even intervals, i.e., $3.00, $3.10, $3.20, etc., aboveand below the current market value (CMV) of the underlying entity. As the CMV increases or decreases, more options are added.If a strike price is equal to the CMV, it is described as at-themoney. If a call has a strike price that is below the CMV, it is said tobe in-the-money. The strike price of a put would have to be abovethe CMV to be in-the-money. An in-the-money call or put has
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TA B L E
2-1
Obligations of Buyers and SellersOption Buyer
Option Seller
Pays for the right, but not the obligation,to a position in the futures market ata set price for a specific time period.
Is paid to assume the obligation todeliver a position in the futures market at a set price for a specific periodof time.Risk equals the maximum amountfutures contract can move beforeexpiring.Reward equals the amount ofpremium paid.
Risk equals premium paid.
Reward equals maximum amountfutures contract can move beforeexpiring.Pays commission and fees.
Pays commission and fees.
intrinsic value (see Figure 2-1). This simply means that theseoptions have real value. You can exercise an option that is in-themoney for a long or short futures position, and that position wouldshow an immediate gain. For example, you own a silver call with a$5.00 strike price. If the CMV of silver is $5.25, you could exerciseit, and the seller or grantor of that option would deliver you a longposition at $5.00. You have an immediate profit in that position of$0.25. If it is a COMEX contract for 5000 ounces of silver, youraccount would be ahead $1250. Don’t forget you would have tohave enough margin money in your account to hold the newfutures position or you would get a margin call. In addition, youpay a commission for exercising your option.The opposite of an in-the-money option is one that is out-ofthe-money. A call that is out-of-the-money has a strike price that isabove the CMV. A put is out-of-the-money when its strike is belowthe CMV. Just think of it as the need for the CMV to catch up to thestrike price. In the case of a call, the CMV or the underlying entitymust go higher before the call is in-the-money. With a put, theCMV must go lower.As you would expect, an option with intrinsic value is moreexpensive than one that is out-of-the-money, all things being equal.When buying an option, you must pay for three things. The first is
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FIGURE
25
2-1
Silver Puts and Calls
$6.00
$5.50
$5.00
$4.50
SL $5.50 PUT
SL $5.50 CALL
In-the-Money
Out-of-the-Money
SL $5.00 PUT
SL $5.00 CALL
At-the-Money
C U R R E N T M A R K E T V A L U E At-the-Money
SL $4.50 PUT
SL $4.50 CALL
Out-of-the-Money
In-the-Money
$4.00A put or a call is at-the-money when the strike price equals the currentmarket value (CMV). A call is in-the-money when the CMV is above thestrike price. A put is in-the-money when the CMV is below the strikeprice.
the time to expiration. The longer the time the seller of the optiongives you for the option you buy to catch up with the market, themore it will cost—again, all variables being equal.Then there is intrinsic value. If the option is already a nickelin-the-money, the seller will expect you to pay that on top of thepremium for time. The last part is the potential of the option to getseriously in-the-money before it expires. This is a function of several variables, the primary one being the volatility of the underlying futures contract, to be discussed shortly.There is a very important negative side to buying options youneed to be aware of and that is that they are considered to be decaying financial instruments (see Figure 2-2). In other words, theyexpire and become worthless. In mid-April, you buy a June $5.50soybean put for 6 cents when June beans are trading at $5.53. It is3 cents out-of-the-money. Note that you must always match up theoption with the underlying entity by contract month. Optionsexpire on the third Friday of the month. If beans do not drop over9 cents, you will lose your $300 ($0.06  5000 Bu.) premium. Itmust be over 9 cents because you would have paid commissions of,
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FIGURE
2-2
Value
Options as Wasting Assets
5
9
8
7
6
5
4
3
2
1
0
Life of OptionOptions are wasting assets because they eventually expire. Their timevalue continually deteriorates as they move toward their expiration date.To make money or conserve losses, you must offset or exercise optionsbefore they expire.
say, $25 to buy and to sell or a cent per bushel on the transaction.Always figure your transaction costs, which are a commission toyour broker, plus NFA (National Future Association) fees (circa $0.25a contract) when calculating breakeven. Add this to the premiumpaid and the amount the option is out-of-the-money to arrive at thebreakeven price.Key point for scale traders: Options normally expire in thethird week of the delivery month, but the underlying futures contracts continue for approximately another week. The last week isoften the most volatile, because traders are offsetting positions toavoid being involved in delivery, while those that are delivering ortaking delivery are jockeying around. Many experienced traders,depending on the number of traders who have filed notice of delivery, are very active in hopes of catching a quick profit due to thevolatility. Since options expire first, your long position would benaked or uncovered the last week if your options are in the samecontract month as your futures contracts. In talking strategy inChapter 4, I will discuss whether you should buy options in the
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next delivery month. For example, when you scale trade Julywheat, should you protect those positions with August options?A large percentage of options expire worthless, or the amateurtraders hold them until the cost of offsetting or exercising themexceeds their value. Floor traders just before expiration exercise manyof these options. It makes money for them because their costs to execute trades are minuscule compared with those of average traders.This practice lowers the statistics on the percentage of options expiring worthless, making the numbers look better than they really are.Don’t let the thought of expiration bother you when we beginusing options to protect futures positions as part of an integratedscale trading strategy. The function of the options is to absorb risk,serving as insurance. Like most insurance policies we buy—car,home, accidental death, etc.—we hope they are not used.Nevertheless, we dutifully pay the premiums to be able to sleep atnight. Always remember why the options are being used.Speculation is not the answer for the scale trader, even though wecan often offset our options at a profit as the price of the commodity moves toward a bottom.Now let’s talk about shorting puts and calls. This will give youa real insight into how the professionals use and think about theoptions market and how you can evaluate options more accurately.If you can buy an option, someone must be selling. The selleris called the grantor and receives the premium the buyer pays forthe put or call. In the example just given, a June $5.50 soybean putwas bought for 6 cents. The $300 went into the commodity tradingaccount of the seller.The seller has the obligation to deliver the underlying futurescontract to the buyer on demand. If the seller sold a put, he or she hasthe obligation to sell a short position to the buyer whenever the buyerexercises the option before the expiration date. If the seller sold a call,he or she has the obligation to sell a long position to the buyer whenever the buyer exercises the option at the option’s strike price.If you are a seller, you never know when you are going to beexercised against. Requests to exercise are assigned randomly bymost clearinghouses against the sellers. What you do know is thatthe owner of the option normally needs a financial reason to exercise it. That means the option must be in-the-money far enough torepay at least the premium paid for the option and the transaction
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costs. Additionally, the owner must have a good reason for wanting to convert the option to a futures contract and assume theadditional risk. Before this happens, most astute option sellerscover or offset their positions. This is a key insight. In my experience as a broker, the sellers were the ones that made money consistently in options. If a substantial percentage of options expiresworthless, someone is the beneficiary. Obviously, it is the sellers.Therefore, you must pay close attention to them, because they setthe prices.Think about the degree of differences in risk between buyersand sellers of options. The only risk buyers have is the premiumpaid for the option and the transaction cost. With the bean optiondiscussed earlier, the buyer pays $300 premium plus $25.25 in commissions and fees. That is it. No matter what happens—soybeansshooting to $15 a bushel or plunging to zero—the buyer has only$325.25 at risk for this $5.50 June soybean put.The seller of that same option has substantially more at risk.The seller must sell a short soybean futures contract to the buyer ondemand. Now the buyer owns the $5.50 put, which costs a total ofapproximately 61⁄4 cents. It will cost the owner one more commission to exercise the option, so soybeans will have to be tradingbelow $5.431⁄2 to entice the owner to exercise it. Further, he or shewill want more bearish news to entice him or her to exercise.But what if beans limit down for three consecutive days? Thelimit move for beans is 30 cents, or $1500 a day from the CMV of$5.53 at the time the put was purchased. At the end of three days,beans would be at $4.63 per bushel. All the owners of $5.50 putswould be screaming at their brokers to exercise (or offset) theiroptions, and the put sellers would be clamoring to buy short positions to cover their exposure. This would naturally drive beanslower. At $4.63 per bushel, one party, the buyers of options, makesa $4050 profit and the other, the sellers, loses $4050 ($0.87  5000bu.  $300 premium).Why on earth would sellers of options in their right mindsrisk losing $4000 or $5500 or more to gain $300? If the optiongrantor sold calls, it could be even more devastating. A short position can only go to zero, whereas long can go as high as infinity,theoretically. In reality, soybeans have traded at over $12 per busheland silver at over $50 per ounce.
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To be blunt most options buyers do not understand options!This is my opinion, based on years of being a commodity and securities broker. Too many buyers do not take the time to evaluate thepotential of the options they buy. There are many, many inexpensive software packages on the market that will calculate fair market value and rate all the options available as to their potential. Isthis the silver bullet to trading options? No, there is none of course.But this is the minimum a trader should do.What all too many part-time traders do is listen to their broker. The broker raises their greed level while taking fear out of theequation. The option buyer has unlimited upside potential whenbuying calls, at least theoretically. Risk on the other hand is limitedto the premium paid. I call the upside theoretically unlimitedbecause I have never seen a commodity increase in value to unlimited heights. The closest I recall is silver when it hit $54 an ounce.But it took most of the Hunt family, with the help of a few Arabprinces, in an attempt to corner that market to get it there. Even so,it did not reach $75, $100, or $500 an ounce.Brokers share overly rosy scenarios of the prospects for a commodity. Most are built on fundamental analysis, which is often easier than technical analysis for nonprofessionals to understand andbelieve. “The analysis of our research department, headed by Dr.Jones, indicates sugar, now trading at a dime, is headed to 60 centsa pound. You’ve seen reports in the paper about the draught inCuba, haven’t you? For just a few thousand dollars you can buy adozen 15-cent calls. You can’t lose! You have no downside risk!”Well, of course, they can lose. Their entire investment is in awasting call option, meaning a potential loss of 100 percent of whatis invested in options. Second, how much time will it take sugar tomove up 600 percent? What are the odds that it will before theoption expires? Worse yet, if the mark does not have “a few thousand” handy, the broker will sell him or her an option that is evenmore out-of-the-money at a lower price that has even a worsechance of getting into the money. Further, the premium and highcommissions charged by such brokerage firms must also berecouped before this option player is ahead.My point is simply that there are an awful lot of options soldthat have only a remote chance of making money for the buyer.Consequently, a high percentage expire worthless. You can bet
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the farm that the seller of the option facing the risk of sugar skyrocketing from 10 to 60 cents a pound—a 50-cent per pound loss(112,000 lb.  $0.50  $56,000)—gave some thought and did someanalysis before offering to sell call options.Key insight: Buying is emotional; selling, intellectual. In thecase of the sellers of options, fear of loss sharpens their analyticskills. Lack of fear on the part of the buyers dulls their senses.Buyers lose because they must predict exactly what will happen;sellers win because they must predict what most likely will nothappen, which is far easier.The second biggest mistake amateur option traders make isholding their positions until expiration. They are always hopingtheir positions will miraculously appear in-the-money one finemorning. Too many think of trading options as gambling. Theymake a bet of a few hundred without ever considering offsettinglosing positions to salvage at least some of their investment. Afterall, you cannot offset a bet. The pros are traders in the truest sense,constantly adjusting their positions as necessary. If an option theyown is obviously not going to be a winner, they offset it to salvagewhat they can before it expires worthless.Finally, those new to options do not realize that investors canlose trading options even if their analysis of the direction of themarket is absolutely correct. Why? Several things can happen.First, as alluded to earlier, they can get talked into an option that istoo far out-of-the-money, one that is deep-out-of-the money bytwo, three, or four strike prices, which would require a move of atleast 6 on the Richter scale to make it worth offsetting or exercising.Another possibility is that it does not have enough time left on itand it will expire before it gets into a profitable price range. Or theoption in question is bought in a commodity that is trading in atight trading range, meaning little or no volatility. It was “sold” tothe investors because it was cheap, not a good reason to buy anyinvestment. In this case, the price of the options remains dormant.In other words, there are several key elements that influence theprice of an option. Let’s discuss the most important of them.Time value may be the easiest to understand, so let’s start withit. When it comes to time, I always imagine options as blocks of iceof various sizes—100-, 200-, or 500-pound blocks. The longer theysit in ambient temperature, the more they melt. Some last for hours
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and others for days. But before you know it, all you have is a puddle of water that is evaporating—then nothing. All options decayover time. Having a fix on the odds of an option moving into themoney, particularly deep into the money, before expiration is crucial. Knowing the odds is one of the key reasons the seller is willing to sell. When time erodes, the seller keeps your premium.The next key element is the strike price. Where is it? In-themoney? Deep-in-the-money? At-the-money? Out-of-the-money?Deep-out-of-the-money? Obviously, the more it is in-the-money,the more you will have to pay for it. Out-of-the-money and deepout-of-the-money options tend to be inexpensive. Why? The sellersdoubt they will be enough in-the-money by expiration to be exercised or offset. The fact that the majority of options expire worthlessattests to the correctness of this assumption.The definition of a deep-out-of-the-money option, by theway, varies by exchange. But the most common way of defining itis as an option that is two strike prices out-of-the-money plus onemore strike price for each month left to expiration. For example,corn strike prices are 10 cents apart. If the CMV of corn is $2.50and it is September, any September calls with strike prices above$2.70 would be considered deep-out-of-the-money, as would anyDecember calls with strikes above $3.00. Puts are classified thesame way, but in the opposite direction. All September put strikesbelow $2.30 and December puts below $2.00 would be deep-outof-the-money.Keep in mind that deep-out-of-the-money options are considered so risky by most exchanges that they require brokers to getadditional disclosure from clients who trade them. This disclosurestates that these options have a very remote chance of becomingvaluable. This procedure is also followed to prevent unscrupulousbrokers from selling uninformed customers worthless options justbecause they are cheap. Remember, the broker gets the samecommission whether an option has a chance of becoming a winneror not.There is another problem with deep-out-of-the-moneyoptions, which leads us to the next key element. Liquidity is theamount of buying and selling that is occurring, in this case theamount of demand for a specific option. With options, there isalways a seller but not always a buyer. Take a second to look at the
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futures pages of the Wall Street Journal and Investor’s Business Daily.Find the options section and the volume of trades for some of theout-of-the-money options. You will be surprised at how low it canbe on any given day. To speculate in options, you need liquidity toallow you to get in and out of trades. As a scale trader, you are buying insurance and waiting patiently for the market to come to you.At times, liquidity is not as important, which means you may beable to pick up some real bargains. I will discuss this further inChapter 4.When you buy an option, you tie up your capital. You do notearn interest on the money used, and the holding period can befor several months or even longer. Therefore, the current interestrate can play a part in the traditional formula used to determinethe fair market value of an option, particularly options of securities. Securities also pay dividends. With futures, because of thehigh leverage and lack of dividends, neither is an important consideration.The key element is volatility. I talk a lot about volatility in thisbook because it is the scale trader’s best friend. Without it, the scaletrader withers and dies on the vine.Volatility is simply a measure of the tendency of the price of afutures contract to move up, down, or sideways. The more pricesgyrate, the greater the volatility. The greater the volatility, the morevaluable options become, because there is a greater chance of anout-of-the-money option becoming an in-the-money option. Thebest friend of the seller of options is no volatility at all or at leastlow volatility. Then the options price goes nowhere and the sellercollects the premium.One of the most common ways of measuring volatility is calculating the standard deviation of price from the means. The classicexample illustrating this concept is the flip of a coin to determinenormal distribution of heads and tails. Extensive experimentationhas proven that no matter how many times you flip a balanced coin,you have an equal chance of getting a head or a tail. Once you determine normal distribution, you can calculate deviation from themean, thus providing a measure of volatility.For example, flipping a balanced silver dollar 225 times—15separate series of 15 tosses each—produces the following theoretical results:
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Series #
# of Heads
# of Tails
123456789101112131415
12368710119564210
14131297854610911131415
With each repetition of this experiment the results vary, but themajority of the time they will be remarkably similar. The most common occurrence will be somewhere in the middle of the spectrum.Flipping all heads or all tails would be a 32,000 to 1 event.It is the normal distribution that needs to be described. It canbe charted on a graph generating the well-known bell curves (seeFigure 6-1). Additionally, lognormal distribution is used to reflectinflation, skewing results slightly to the positive side. Normal distribution represents a statistically valid estimate of what can beexpected. The key word is estimate. The peak of the bell curve represents the average price data. The mean is calculated by multiplying the number of event-results on one side (either the number ofheads or tails in the coin flipping example or say, closing prices inthe case of a futures contract) by the number of flips and dividingthe total by the total number of event-results. Here are the results ifwe use the heads event-results:Flips1122
# of Heads Event-Results
14
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334658677  108  119910  511  612  413  214  115  0

Totals 75563 divided by 75 
9244042708881506648261405637.5067
The mean or average is approximately 7 1⁄ 2 or half of 15, as logic andexperimentation dictate. That is what we expect when we flip a balanced coin. It also provides the data needed to construct a bellcurve.The area within the bell curve defines all the random pricemoves that would fall within one standard deviation from the meanor 68.3 percent for all occurrences. Therefore, approximately twothirds of all price activity should occur within the bell curve, whichis calculated using all the price data available over a selected periodof time. It could be a day, a week, a month, a year, or all the pricehistory available. It is important to study various time frames ofvolatility to establish patterns and determine what the normalranges are for the option and the underlying entity being traded.This is a key insight, as you will see later.The flatter the curve, the more price diversification or highervolatility. Or the narrower the pattern, the less prices are diverse.There is no need to worry about learning how to calculate bell curves.You can find volatility charts on various Web sites on the Internet (e.g.,www.optionetics.com). Additionally, there are other ways of evaluating volatility (see Table 9-1). My point is that as a scale trader youwant to trade commodities with reasonably high volatility.
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Additionally, scale traders must become sensitive to the different types of volatility. Since it is basically a result of a mathematicalcalculation, it is a snapshot frozen in time. A minute, an hour, aweek, a day, a month, or a year from the time the calculation ismade, the bell curve could change, perhaps even drastically. Also,with physical commodities there are times of the year when theirprices are more volatile. The price activity of grains, for example,increases when supply begins to dwindle and production is in question. In the summer, crops