premiums canrange from a few hundred dollars to thousands of dollars.The premiums on options can change from day to day, hour tohour, and minute to minute. It all depends on the price activity ofthe underlying futures contract. Also, it is important to note that options prices do not move in lockstep with the price of the underlying futures contract. For example, a 1-cent rise in the price of Julysoybeans does not mean the option on July soybeans rises by 1 cent.However, the premium on an option that is significantly in-themoney will tend to move in synchrony with the underlying price ofthe futures contract. The less time an option has remaining until expiration and the deeper it is out-of-the-money, the smaller the premium response is likely to be in relation to a change in the underlying futures price.A trader can buy an option or sell (many times called write) anoption. There are some big distinctions between the two, however.The options buyers—either puts or calls—have limited their financial risk to the price they paid for the option, including their brokerfees. There should be no margin money required by the broker inthe case of buying options. However, the options sellers (writers)have an unknown risk factor, just as do traders who trade thestraight futures contracts. Options writers will likely have to postmargins with their brokers.Winning trades can happen before an option expires or after anoption has expired and automatically becomes a winning positionin the underlying futures contract. If an option is in-the-money onexpiration day, it automatically converts into a winning straight futures contract position. However, most options buyers that havewinning trades offset their positions before the option expires.If you are an options buyer, you can take profits on a winningtrade by simply telling your broker to offset your position. For ex-
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ample, if it is June 3 and you own a July soybean call option that isworth more than you paid for it (the premium is higher) and youwant to take your profits, simply call your broker and instruct tosell.The options writers (sellers) make their money by keeping thepremium they receive from the options buyers—and hoping the options never get exercised (or are in-the-money) at the options’ expiration. If the options they sold to the buyers are in-the-money at expiration, they have losing trades.A beginning trader is wise to buy options as opposed to selling(writing) them. Most of the winning trades in options are made bythe writers (who are usually professional traders)—and not by thespeculative buyers. Still, writing options should only be consideredby veteran traders with deeper pockets than the beginning traderhas.There are complicated options trading strategies about whichentire books could be and have been written, but to better illustratethe advantages of a trader starting out using options on futures, acouple of conservative trading methods for beginners will suffice.The first example involves a newer futures trader who has established a long or short position in a market, with one futures contract only, and has set tight stops. This is indeed a conservativemethod of trading. However, the fact that the trader placed a tightstop does not guarantee the position will offset (the order “filled”)at that stop level. If an unforeseen event occurred to push pricesright past the stop (in a price vacuum), the trader could lose muchmore money than planned by placing tight stops. In extreme cases,a locked-limit move against the trader’s position could cost the trader a huge sum of money. These cases are uncommon, but they dohappen. In any given month, looking across the commodity futuresspectrum, you’ll likely find a few markets that have made limitmoves during that time frame.The second example features a newer futures trader who hasdecided to start out trading on the Mid American Exchange, a subsidiary of the Chicago Board of Trade. On this exchange, individualfutures contracts are much smaller in size, meaning less financialrisk for each contract traded, than their counterparts at the Board ofTrade. Still, the same rules apply as in the first example. Risk is less,but still an unknown.
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With those two examples in mind, a newer trader may feeluneasy about the potential of losing big money trading futures.The trader is especially uneasy because the business is still beinglearned. This trader has read that a great way to learn about futurestrading is to do it on paper first, but that’s been done and it is timeto test the waters with real money.Buying a put or a call option that is out-of-the-money is a good,inexpensive way to wade into futures trading. The money the trader lays out to the broker for the option is all this trader has to worry about. No margin money. No margin calls. The trader can sleepwell at night while still trading futures, learning the business, andhoning market skills.So why doesn’t every beginning futures trader start out trading options? One reason is that the market may move in the rightdirection for the options trader, but because the trader’s option isout-of-the-money, the premium (the price of the option) only risesslightly or not at all.Compare the out-of-the-money futures options buyer (in thiscase, a call) with the straight futures contract trader in the same market. It is mid-May, and July soybean futures rise by 10 cents duringthe trading session. The straight July soybean futures contract trader has just made $500 ($50 per 1-cent rise in price). However, the Julysoybean option trader holding the call maybe makes a penny ($50).The options trader needs prices to move closer to being in-the-money, or to actually move into-the-money, before realizing the sameprofits as the straight futures trader. In some cases, an options trader can be right in forecasting the move (the trend) of the market, butwrong in timing the trade. The option could expire before it movesinto-the-money.What the options trader is doing is giving up some profit potential for the sake of limited risk and likely peace of mind. That’sthe trade-off in trading options versus straight futures.What about the trader that still wants limited risk but doesn’twant to buy options because it is more difficult to realize profits?There may be a happy medium for some. A trader can enter into astraight futures position and also buy an out-of-the-money optionand have limited risk.It’s early May and a trader is bullish soybeans and wants to enter into a long position in the July futures contract. The price of July
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soybeans is currently $4.50 per bushel. The trader can enter into along position in July soybean futures—and also buy a put option onJuly soybeans with a strike price of, say, $4.25. For the few hundreddollars that are paid for that put option, the overall risk of loss hasbeen limited to $1,250. If the trader feels the $4.25 strike premium istoo pricey, a $4.00 put may be opted, but the risk of loss has been increased to $2,500.As you can see, there are profit-potential costs in reducing trading risk by using options, but for many fledgling futures traders, being safe is much more desirable than striking out with unknowntrading risk.BUYING OPTIONS INTO A BULL MARKET
By nature, most people come to commodity trading as bulls. It justfeels more comfortable making money when prices are rising, ratherthan taking advantage of a declining market. An additional reasonis that bull markets usually last longer than bear markets, whichgives more time to trade them.Options are an excellent investment tool to take advantage ofan upcoming bull market. You can plan your trades enough in advance to be in the right market at the right time. Once a commodity with bull market tendencies is spotted, the trader begins to studythe price charts looking for stage 2 or 3 where the long-term downtrend is broken, followed by a modest rally or a shallow uptrend.These are the signals to get into a call that is in-the-money ornear-in-the-money. You’ll want one with as much time left on it aspossible. At this point, you are acting contrary to what most tradersare doing. They are still on the sidelines totally unaware of the developing situation.You ride the bull market through stage 6. Again you want to bea contrarian and take your profits before the blow-off top. It’s timeto remember again that “bears win, bulls win, but hogs get slaughtered!”Many traders, after successfully making profits in stages 3, 4,and 5, hold out to pick the top. This is a very dangerous strategy. Asmentioned earlier, the market usually declines substantially fasterthan it rises. Those who wait are often disappointed. Options trading is risky business. You can easily lose your entire investment. The
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surest way to do that is to overstay a position or to try to pick topsor bottoms.When the blow-off top begins, you again do the opposite ofwhat most traders are trying to do. Instead of getting in the marketlong, you’re looking for a put that is reasonably priced with enoughtime to take advantage of the impending bear market. Success in thecommodity market often means thinking and doing the opposite ofwhat most traders would do in the same situation. You buy your callbefore other traders have spotted the opportunity and sell the dayyou see a story about the price run-up of your commodity on thenightly news.If you understand herd psychology, you’ll be better prepared.A trader must be able to see reality for what it is in order to profitably trade reality. Traders get caught in a powerful mass delusionthat causes them to lose control of their trading. The contrary trader must be prepared to recognize these situations and take advantage of them. Commodity trading is complex and vague. WhenCTAs, journalists, brokers, and newsletter writers get caught up inthe image of what “everyone” thinks is happening, they can whiptraders into a wild frenzy. This pulls the average investor in off thestreet. Everyone thinks the market will never stop.You, as the contrary trader, recognize it as a blow-off top of aclassical bull market. You need the discipline that comes with an understanding of the mass psychology to overcome this trap. Add tothis the courage to stand up to your broker who says, “You want tobuy a what? The market isn’t even halfway to my first objective.”Contrarian traders study open interest and volume. Volumelets them know how active or how “hot” the markets are. The hotter they are, the more emotional they become, which gives strengthto major moves. Open interest is even more important, especially ifyou can determine who is holding the positions.One way to learn who’s doing what is to study the daily reportssupplied to the Commodity Futures Trading Commission. TheCFTC requires clearing members of the exchanges, futures commission merchants, and brokers to report each trader’s position ontheir books that, in any future month of a commodity, exceeds certain levels. These are the large traders usually with “strong hands”and good information sources.Here are a few examples of the reporting levels by commodity:
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Commodity Reportable LevelCorn750,000 bushelsSilver150 contractsTreasury notes500 contracts
Besides supplying the CFTC with the number of contracts, thereporting entities must also classify them as noncommercial or commercial. Commercial traders are hedgers as defined by the commission’s regulation. These are usually companies, even countries, thatare willing to take physical delivery of the commodity and use it intheir business. An example would be a grain merchant who hedgesan upcoming cash sale on the futures markets. Noncommercials include individual traders. Nonreportable positions are ones that arebelow the reporting limit.This information is often published in commodity newslettersand other periodicals on a weekly or monthly basis. It is put into index or graph formats known within the industry as the bullish orbearish market opinion or consensus.Traders must also study the data to determine if a market isoverbought or oversold. They use the data as a guide to determinewhen to switch from the long to the short side, or vice versa. Theproblem the contrary investor faces is avoiding getting caught up inthe illusions and mass hysteria that fast-moving and rapidly risingmarkets create. You need rules to follow to avoid this pitfall. For example, when they see the open interest numbers rapidly increasingin nonreportable positions (the small traders) and decreasing in reportable positions (the large traders), good contrarians may conclude that the “public” has a hold of the market. This means it maybe time to begin picking an exit or reversal point.Another important indicator of the general thinking of tradersis the number of puts or calls for each option. If there are substantially more calls, most options traders are bullish. More puts indicate a bearish outlook. These numbers are found each trading dayon the Commodity Page of the Wall Street Journal.Since most people, including traders, are followers rather thanleaders, by the time the majority get on board, it is time to switchsides of the market. An excellent example occurred when the stockmarket crashed on October 19, 1987. On Friday, October 16, therewere 32,045 calls and 30,087 puts. On the day of the crash, there were
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34,971 calls and 25,685 puts. The next day saw 35,183 calls and24,327 puts. A week later there were still more calls than puts—38,346 versus 25,432.The contrary trader knows the majority does not rule the commodity market. The best opportunities materialize when you resistfollowing the crowd.DEVELOPING AN OPTIONS TRADING SYSTEM
If you’re planning to trade options rather than futures, the tradingsystem you develop may need some extra refinements. The value,and therefore the price movement, of an option is related to the pricemovement of the underlying futures contract. If the price of the underlying futures trends upward, so will the price of the option inmost circumstances. The same is true in bear markets.However, options on futures are distinctly different from theunderlying futures market. They have characteristics that sometimes cause their price movement to react differently from the futures on which they are based. You must keep these differences inmind when you attempt to relate the signals from a futures tradingsystem to the anticipated price action of an option. And you cannotevaluate an options trading system exactly the same way you do afutures trading system.SIMILARITIES AND DIFFERENCES
The special attributes of options bring their own set of problems toinvesting. The premium values for options are determined by a bidoffer open-outcry auction, just as futures prices are determined.Buyers and sellers of options get their lead from the futures markets.Other important considerations, however, make options trading less responsive to those trading systems that are used successfully in futures trading. First, consider the delta factor. It is the value change of the premium price relative to the price change of theunderlying futures market. Under optimum conditions the deltafactor for an option will be 0.5, meaning that the value of the premium will move 50 percent of the value of the price change for thefutures market.If you are considering a trading system that has performed
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well for futures markets, then you would have to make an adjustment to compensate for the delta factor. In other words, if your futures trading system anticipates a 50 percent increase in the price ofthe underlying futures contract and the delta was 0.5, you wouldlook for a 25 percent increase in the price of the option.It is typical for lower-cost premiums (i.e., out-of-the-money) tohave low delta factors, thus reducing the positive effects of the highlevel of financial leverage provided by options. Actually, in-themoney options will provide the closest relationship between options and futures. They can have a delta approaching 1.KNOWING THE DANGERS OF LIQUIDITY
The problem of slippage is compounded in the case of options. Thereason is that for each individual commodity option, there are alarge number of strike prices. For each strike price there are bids andoffers for puts and bids and offers for calls. Also, actively traded options have less liquidity than actively traded futures. Therefore, youmust plan for a wider disparity between the bid and offer prices.To be assured of a fill, the premium of an option must trade ata price significantly less than the price offered. In other words, to befilled with an option at a premium of 10, it may be appropriate toonly consider a fill if the premium drops to 8 when calculating hypothetical results.In the case of nearly every option on futures markets, the expiration or declaration date precedes by a number of days the lasttrading day for the underlying futures markets. Since the option expires first, it may lose the benefit of the trading period within whichthe futures market most resembles the “real-world” cash market.Before you can complete your trading plan, review some of thebasic trading strategies. The most common is simply taking long orshort positions in either the futures or options markets. If youranalysis indicates that the futures contract you are interested in istrending, or going to trend, high, you go long. This means you contingently agree to deliver whatever the futures contract calls for onthe date the contract expires at the price specified when your futureorder is filled. (See the Appendix.)To illustrate, a June corn contract on the Chicago Board ofTrade calls for the delivery of 5,000 bushels of No. 2 corn. The No. 2
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grade specifies the quality (moisture content, cleanliness, etc.). Yourfill price is $2 per bushel, or $10,000 total value for the contract.As mentioned earlier, only a small percentage (2– 3 percent) ofcontracts are actually taken to delivery. Most are offset by taking anequal and opposite position to the one already established.Therefore, if you own (long) 5,000 bushels of corn at $2.00 perbushel and you sell it (go short to offset your long position) 30 dayslater at $2.50, you make 50 cents per bushel, or $2,500, for the 5,000bushel contract, less brokerage commission and fees. If, on the other hand, the market goes against your position and you have to sellat $1.50, you lose 50 cents per bushel, or $2,500, plus the transactioncosts. This is a sample of the risk and reward of futures trading.You could have just as easily taken the opposite side of the tradedescribed above if you felt corn prices were trending downward. Inthis case, you would have initially sold (gone short) a futures contract for corn and then later bought it back (offset). When you areshort, you’re contingently agreeing to accept delivery of a commodity at a given price by a given date. The lower prices go, the moreprofit you make when you “buy it back at a lower price” (offset).OPTION STRATEGIES
Option trading strategies are basically similar to futures strategies,but a call option replaces a long future position and a put replacesa short. Investors who are new to the futures markets often startwith options because the maximum risk can be defined in advance,while the risk of trading futures cannot be.UNDERSTANDING BASIC OPTIONS CONCEPTS
The buyers (sometimes called holders, takers, or longs) of optionshave the right, but not the obligation, to receive a position in theunderlying commodity futures contract at a predetermined price(strike price) on or before a specific date (expiration date). Unlike afutures contract, which requires the purchase or sale of a commodity if held to maturity, the buyers of options may elect to let the options expire without exercising the rights.When an underlying commodity increases in value, the premium of the option on that commodity usually increases in value at
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the same time. Options traders, just like futures traders, can thenclose out their positions by taking equal and opposite positions. Ifthe options have increased enough in value, the traders will make aprofit. If not, they can close out their positions at breakeven or a loss.The buyers of options even have a third option, which is to exercise the options. This means the buyers convert their options to futures contracts and assume the risk of holding the futures positions.This defines the rights and opportunities of the buyers of anoption. They pay a premium (plus commission and exchange fees)and can take one of the three actions described above. Their risk islimited to the total amount that they initially invest in the options,while the profit potential of the options and of the underlying commodity futures contract is unlimited.PUTS AND CALLS
The two types of options are the put and the call. A call option givesthe purchaser the right to acquire a long position in a futures contract at the strike price on or before the option’s expiration date. Callpremiums typically increase as the futures price increases, thus benefiting the call buyer. Calls can also be employed for protectionagainst rising prices. If you call, you’ll want to own the commodityin the future because it is increasing in value. You are basically calling something to you.A put option gives the option purchaser the right to acquire ashort position in a futures contract. Put options are the type that maybe most useful in seeking protection against declining prices, because the premium of a put tends to increase in value as the futuresprice declines.RIGHTS VERSUS WRITERS
The term right refers to one of the primary differences between futures and options. With futures, an obligation is created for both thebuyers and the sellers. The buyers must be willing to take and thesellers must be willing to make delivery unless the positions are offset prior to delivery. In the case of options, unilateral obligation isplaced on the “writers” (also referred to as sellers, givers, or shorts) ofthe options—that is, only the option writers are obligated to perform. The buyers of the options may exercise the options, but they
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may also decide to abandon them, letting the options expire. In theevent the options are exercised, the option writers must deliver theunderlying futures positions.In return for assuming these obligations, the writers of the options receive payment of the premiums from the buyers. The premiums must be paid in full in cash when the options are purchased.The buyers are paying for specific rights. The sellers agree to grantthose rights and are paid for assuming the risks of offering options.To the writers, the premiums are the maximum profit availablein the trade. However, if the value of the options rises, the writermay have to deliver futures positions, or cover their short sale at ahigher price, thus incurring a loss. If the value of the options decreases, the short sales are profitable, but the value can only decrease to zero, thus placing a limit on profits. The intrinsic value ofa call option declines to zero when the price of the underlying futures contract falls to the strike price or below.COVERED AND UNCOVERED OPTIONS
As in the futures market, for every buyer there must be a seller. Inoptions trading, option sellers (writers) must be prepared to enterappropriate futures positions opposite that of the option buyers, toaccommodate buyers if the options are exercised. Option writersmay be considered as “covered” or “uncovered.” Call option writers are covered if they have long futures contract positions beforewriting calls. Put option writers are covered if they have short futures contract positions before writing puts. If either one of thesecovered options should be exercised, the writers would have the appropriate positions to deliver to the buyers of the options and wouldnot have to acquire the position at the current, probably unfavorable, market prices.Options that are not written against an existing position in underlying futures contracts are called uncovered options. If the adversemovement of the futures contract price is greater than the premiumreceived, the writers of the contracts lose.Therefore, you have four basic strategies to consider with options. You can buy calls, buy puts, sell calls, or sell puts. The novicetrader should avoid selling calls or puts because of the unlimitedrisk. Buying calls or puts is a better choice since risk can be calculated exactly in advance.
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OPTIONS PROVIDE STAYING POWER
Perhaps the most salient difference between options and futures isstaying power, or the ability to withstand adverse market moves.With futures, both the buyer’s and the seller’s risk is theoreticallyunlimited, and both parties are in jeopardy of the market movingagainst their position. Options, on the other hand, have a definedrisk. The premium and transaction costs represent the total amountthe buyer has at risk.If the options trader forfeits the options or lets them expireworthless, there is no further financial obligation. Due to this uniquesituation, the buyer is not required to provide margin or face the potential of margin calls regardless of where the underlying futuresprice moves during the life of the option. No matter how far thetrade moves against the position, the buyer can hold the option inanticipation of an eventual turnaround in the market that will makethe buyers position profitable.
THE PREMIUM
Who determines the amount of this payment? Options are traded inan auction-type environment (similar to futures) at a registered exchange with bids and offers made by an open outcry. There are,however, some guidelines for determining the option pricing models that mathematically calculate the theoretical value of an option.Computer software programs are also available.The premium of an option is composed of its intrinsic valueand its time value. Intrinsic value is the amount an option would beworth if it were to expire immediately. For example, if soybean futures were trading at $5.60 per bushel and your call option gaveyou the right to buy soybean futures at $5.25 per bushel, you wouldhave an immediate profit of 35 cents per bushel and should be willing to pay at least 35 cents per bushel for that option. This call option with a strike price less than the market price is said to be inthe-money.A put option is in-the-money when its strike price is above themarket price. Using the example above, the right to sell soybean futures at $5.95 per bushel is worth an immediate 35-cents-per-bushelprofit, and this 35 cents is the intrinsic value of this put option.A call option with a strike price above the current market price
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is said to be out-of-the-money. The right to buy soybeans at $6.00per bushel when they can be had on the open market for $5.60 perbushel is intrinsically worth nothing, but there may be a processoror soybean crusher (an inventory manager) who wants to assurehimself the right to buy soybean futures at $6.00 in the event themarket rallies higher than $5.60.A future (or time) value may also be bid into the price of thisoption. There may be a producer who anticipates a sharp declineand wants to ensure selling soybean futures at $5.00 per bushel later even though they are at $5.60 per bushel now. When the strikeprice of a put is below the current market price, it is also out-of-themoney.When the strike price of an option, put or call, is exactly at thecurrent market price, it is said to be at-the-money. With soybean futures at $5.60 per bushel, a $5.60 option still has no intrinsic value.But there is a high probability that it will gain intrinsic value, giventhat only a small move in the market would be needed.The second component that makes up the option premium istime value. Time value is somewhat less specific than intrinsic value.It is based entirely on the future expectations of price movements.By definition, time value is the amount of the premium that exceedsintrinsic value. However, this definition hardly seems complete. Tounderstand time value, some factors that contribute to the creationof this value should be explained.In general, the more time until expiration, the greater the value. Common sense would dictate that all else being equal, the rightto buy something is worth more if you have a year to decide insteadof only 6 weeks. The options buyer is asking the writer to prepricehis product regardless of future events. The writer must be paid forthis risk. Logically, a year’s worth of risk costs more than 6 weeks’worth. (See Figure 7.1.)OTHER PREMIUM PRICE DETERMINANTS
Option premiums are also affected by short-term interest rates; thatis, higher rates may result in lower premiums. Options are competing with other instruments for the investment dollar. If the competition’s rate of return is lower, options need not be priced as attractively, and premiums will be lower. It is further assumed thatthe required margin for options will be met using interest-bearing
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F I G U R E
7.1
Time Value of Options
Options are wasting assets, because they eventually expire. Their time valuecontinually deteriorates as they move toward their expiration date. To make money or conserve losses, you must offset or exercise options before they expire.
instruments so as not to lose efficiency in the use of investmentfunds.Volatility is probably the most obvious and least understoodinfluence on option prices. While there may be many mathematicalexplanations for volatility, common sense is the best rule. If soybeanfutures are at $5.60 per bushel, and will remain at that price for ayear, there is little risk in selling a $6.00 call option. However, if soybean futures trade between $5.25 per bushel and $5.95 per bushel inthe same week, there is significantly greater risk associated with the$6.00 call option.Once again, the writer of the option must be paid for assumingthe risk. The greater the likelihood that the option will trade throughthe strike price, thus increasing the chance of the buyer exercising theoption, the higher the premium must be to accommodate the risktaken by the writer.The common thread running through each of these components of time value is risk. Anything that increases the writer’s riskwill increase option premiums, regardless of the source of risk. Anytime the amount of risk decreases, option premiums fall.
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