; asprices rally you will be willing to pay more for the right to buy (call options) andyou will be offering less for the right to sell (put options). Indeed, forecasting rallies and breaks in the underlying futures is the whole point of options investing!But what is the exact relationship?More precisely, it is the option’s strike price in relation to the underlying futures that influences the option price. Again, this is intuitive. You will be willing to
146
THE COMPLETE GUIDE TO FUTURES TRADING
pay more for the right to buy gold futures at $400 than at $450. In the case of putsit is the opposite; you are willing to pay more for the right to sell at the higher priceof $450 than to sell at only $400.You’ll need to know some important terminology to consider further this relationship between strike price and underlying futures. A call option with a strikeprice that is above the price of the underlying futures is said to be out-of-themoney. A call with a strike price that is below the price of the underlying market issaid to be in-the-money, and for a strike at or around the same price of the underlying it is at-the-money.For a put it is reversed. With a strike price that is below the price of the underlying futures a put is out-of-the-money, and for a strike price above the underlyingmarket it is in-the-money. However, as with calls, a strike around the same price ofthe underlying is referred to as being at-the-money.Those terms can be confusing on the first read-through, but here’s why theyare mentioned. An option’s value consists of two elements—time value and intrinsic value. As long as some time remains until expiration, an option’s price willhave some time value in it (although it might be barely measurable).But this intrinsic value depends on the relationship of the option’s strikeprice to the underlying. An in-the-money option will have intrinsic value, as itcould be exercised and turned into an underlying futures position at a favorableprice. For instance, if S&P 500 futures are trading at 1195.00, the 1190 calls arein-the-money by 5.00. The 1190 calls will be worth 5.00 plus any time value(time value is discussed further later). In contrast, the 1200 calls are out-of-themoney, have no intrinsic value, and will be worth only the time value remainingin the options.Perhaps you’re wondering how much the option will gain or lose for a givenchange in the underlying futures price. This is a good point to introduce some ofthe option Greeks, the mathematical relationships inherent in options. Withoutgoing into the details of the math, here is what you need to know. Delta is themeasurement of how much the option will move for a given change in the underlying price. For instance, if gold futures rally $10, from $410 to $420, the 400strike price call might increase $6. In this example the delta is .6, because the callincreased 60 percent of the change in the underlying ($6 = 60 percent of the $10rally in gold).Different options have different deltas, and the delta of an option changesboth over time and as the underlying futures move up and down in price. The goodnews is that professional market makers spend their entire days making sure thatoptions remain in line with each other, a process called arbitrage.Your quote service will likely list for you the deltas of options you’re interested in. Check the deltas to see how volatile your options are—to get an idea ofhow much they might move if your forecast of the underlying market is correct. Inour example, if you predict a $10 rally in gold, then all things being equal, the 400strike call with a delta of .6 should increase in value about $6.
Options on Futures: A Flexible Trading Tool
147
But, remember that other factors are in play—volatility and time decay, toname two. Let’s consider this example under other conditions. What if your predicted $10 rally takes many weeks to occur? What if it happens unexpectedly?Volatility An option on a volatile market is worth more than an option on aquiet market. Again, you know this intuitively; a market characterized by sharpswings and sudden spikes has a greater chance, simply from random movement,of moving in a favorable direction for the option buyers. You will be willing to paymore for such an option; or looked at another way, you would demand greatercompensation (a higher price) to be the seller of this more volatile option.In our gold futures example, if the $10 rally happened in two minutes because ofsome surprise news, the 400 strike call might increase much more than the expected$6 (60 percent delta). It might instead rally by $7.60, $8.20, $9.00, or more, and its new,higher delta would reflect the new increase in volatility. After all, if gold futures justrallied suddenly on surprise news, who knows what is going to happen next? Uncertainty about the price of gold has suddenly increased, and now all options reflect anew consensus on higher volatility. This new “volatility premium” may cool off in afew days, or it might continue to increase as the surprise event develops further.Notice that an increase in volatility increases the value of both calls and puts,helping options owners and hurting options sellers. Conversely, decreasing volatilitylowers options values, helping those investors who have sold calls and puts. In options jargon, investors can be categorized as being “long volatility” or “short volatility”—that is to say, either owning options or having sold them. Taken to an extreme,complex delta neutral spreads can be crafted that have little or no exposure tochanges in the direction of the market, but, rather, focus on changes in volatility only.Volatility can be determined in several ways. Implied volatility can be calculated with the options math formula (most typical is the Black-Scholes option pricing model) used to value options. Instead of solving the formula for the optionprice, an analyst can plug in actual current market prices and solve instead forvolatility. The true volatility can also be measured directly from the underlying futures contract and plugged into the option pricing formula. Small differences ofopinion can occur about volatility because different time periods will produce different results. Regardless of how volatility is obtained, it can be compared againsthistoric volatility to determine generally if it is high or low.Notice also how delta increased when the volatility increased. This points outthe interdependence of all the Greeks. A change in one measurement will causechanges in the others. Again, without getting into the math, just consider it logically;if volatility is higher, then an option is going to change more rapidly for a given movein the underlying future. It would also stand to reason that with a higher-volatilitypremium, the option will have more time value to lose each week (discussed next).A somewhat esoteric Greek worth mentioning is vega (sometimes known as kappa),which is the change in option price given a one-percentage-point change in volatility.We’ve just discussed examples of a price move occurring suddenly and in the
148
THE COMPLETE GUIDE TO FUTURES TRADING
process affecting volatility premiums. Now consider what happens when a pricemove takes weeks to occur.Time Value An option with a great deal of time remaining is worth more thanan option that is close to expiring. As with the other factors discussed so far, timevalue can be proven and measured mathematically. But disregard the math fornow and consider this instinctively; an option with only two days remaining willhave less of a chance of experiencing a large favorable move than one with twomonths remaining. You will be willing to pay more for an option with more time remaining on it. As a seller, you will demand more money to write an option that exposes you to several more months of risk.Remember, at any given time an option has priced into it the probabilitythat the underlying market will move in its favor, and this depends heavily onthe amount of time remaining. With every week that passes, the time premiumof the option is lessened. You can easily imagine a scenario where any gainsfrom the market price moving favorably might be completely offset by the decay of time value.Perhaps you’re wondering just how much time value an option will lose eachweek. Theta is the component from the option pricing formula that measures timedecay, and is the change in option price given a one-day decrease in time to expiration. But how would you like a quick nonmath estimation to view your time decay risk? Simply look up the number of weeks remaining before expiration andcalculate what percentage one week represents. With seven weeks to go, oneweek later the option will have lost about one-seventh of its time value.Notice that we did not say it will lose one-seventh of its total value. In somecases the total value of the option will indeed be all time value, but not always. Remember, the price of in-the-money options will also include intrinsic value. Onlythe time value portion of an option’s price will decay over time.Here’s another important feature you need to know about time decay. It isnonlinear, that is to say, time decay erodes more quickly in the final days andweeks before expiration than with many months remaining. Walk yourselfthrough the estimation trick in the earlier paragraph to prove this intuitively.With 10 weeks remaining, one week of decay is a 10 percent loss in time value;with only two weeks remaining the same one-week decay represents a 50 percent loss. Not surprisingly, this is an important factor when considering youroptions strategies.Continuing with our gold futures example, let’s say gold futures are trading at$425.00, the 450 calls settled at a price of 10.50 (worth $1,050), and the 400 callssettled at 35.50 (worth $3,550). The 450 calls are out-of-the-money, so the entire10.50 is time value. Notice the 400 calls are in-the-money by 25.00 points, and sothe value of 35.50 equals 25.00 (intrinsic value) plus 10.50 (time value). Only the10.50 time value portion of each option’s price is subject to time decay.One final note: Time decay is steepest for at-the-money options. This is be-
Options on Futures: A Flexible Trading Tool
149
cause they have the greatest amount of time value and therefore the most to loseeach week.Futures price, volatility, and time value are the three most important factors affecting the price of an option. However, you need to be aware of two other elementsimportant to an option’s value—interest rates and marketplace supply and demand.Interest Rates The prevailing interest rates in the economy impact the valueof an option. Indeed, interest rates are an element in formal option pricing models.The reason is that options are highly leveraged, so they tie up only a portion of themoney that would otherwise be required to invest in the underlying futures contract. This means institutional investors save on their cost of capital, and that factor influences the option price.The interest rate Greek is rho, which is the change in option price given a onepercentage-point change in the risk-free interest rate. The sensitivity of options tochanges in interest rates is generally very low, especially at low interest rate levels.Supply and Demand As discussed earlier, ultimately it is the marketplace thatdetermines the price of an option. For this reason, options often trade at levelsabove or below their theoretical value (as determined by comparing them to otherrelated options).When this occurs, the mathematical explanation is simply that the market ispricing in a different volatility premium for those mispriced options. This difference in pricing may continue for some time or may unwind itself quickly, but whileit occurs it is difficult to say the price is wrong.Another important marketplace issue is liquidity. A general rule for any financial instrument is that the more participants who are trading it the better the liquidity will be. You know this intuitively; more participants in a market can meangreater competition among buyers and sellers. Accordingly, the spread between thebids and offers will become tighter and thus the quality of fills likely will improve.As with any exchange-traded instrument, supply and demand is the big wildcard in pricing of options. During hectic periods, both opportunities and risks canincrease.
Reading Futures Option QuotesInvestors new to futures options are sometimes intimidated by the simple task ofdetermining what the different options will cost. Unlike stock options, where eachone is priced the same (dollars per share), futures options require you to find outthe different tick values of each underlying commodity. Being unsure of the tickvalue of any particular market is a terrible reason to miss the opportunities thatmarket may be offering you.Table 9.1 lists some common futures options markets and explains the tickvalues for each. Notice the table includes the size of the underlying contract to
150TABLE 9.1 Common Futures Options MarketsMarket
Contract Size
Value ofFull Point
Value of 1 Tick
Option Quote Example
FinancialsBig S&P 500 futuresE-Mini S&P 500 futuresMini-Sized Dow futuresEuro Currency futuresJapanese Yen futuresU.S. 10-Year Note futures
$250 × Index$50 × Index$5 × Index125,000 Euro12,500,000 Yen$100,000 Face Value
1.00 = $2501.00 = $501.00 = $5$12.50 per point$12.50 per point1-00 = $1,000
0.10 = $250.25 = $12.501.00 = $50.0001 = $12.500.000001 = $12.501/64 = $15.625
“1350” = 13.50 = $3,375 (13.50 × $250)“825” = 8.25 = $412.50 (8.25 × $50)“160” = 160 = $800 (160 × $5)“180” = .0180 = $2,250 (180 × $12.50)“238” = .000238 = $2,975 (238 × $12.50)“3-48” = 3 48/64 = $3,750 (3 48/64 × $1,000)
MetalsGold futuresCopper
100 oz.25,000 lbs.
1.00 = $100$2.50 per point
0.10 = $10.005 points = $12.50
“310” = 31.0 = $3,100 (310 × $10)“230” = 2.30 = $575 (230 × $2.50)
EnergiesCrude Oil futuresHeating Oil futuresUnleaded Gasoline futures
1,000 barrels42,000 gallons42,000 gallons
1.00 = $1,0001 point = $4.201 point = $4.20
0.01 = $101 point = $4.201 point = $4.20
“60” = .60 = $600 (60 × $10)“90” = 90 = $378 (90 × $4.20)“260” = 260 = $1,092 (260 × $4.20)
AgriculturalSoybean futuresLive Cattle futuresCocoa futuresSugar futures
5,000 bushels40,000 lbs.10 metric tons112,000 lbs.
1 cent = $50$4 per point1 point = $101.00 = $1,120
1/8 cent = $6.252.5 points = $101 point = $101 point = $11.20
“8 6/8” = 8.75 = $437.50 (8.75 × $50)“170” = 170 = $680 (170 × $4)“70” = 70 = $700 (70 × $10)“140” = 1.40 = $1,568 (140 × $11.20)
Options on Futures: A Flexible Trading Tool
151
help you understand how the different pricing for each option came about. Don’tfall into the common beginner’s trap of agonizing over where the decimal pointshould go for each commodity quote; even the financial newspapers don’t alwaysfollow the same conventions. As a practical matter, industry professionals knowthe contract size of each market but they focus instead on the individual point values and think in terms of how much money is being made or lost for a given move.Accordingly, the table provides you with a real-world example of how each optionvalue can be calculated.Now that you have reviewed the mechanics of futures options, let’s see howthose principles can be used in specific strategies.
BASIC FUTURES OPTIONS STRATEGIESOptions themselves can be very straightforward. Still, beginners will sometimesbe overwhelmed because options strategies, especially options used in combinations, can be very powerful. We’ll begin first with basic strategies and buildfrom there. In all of these examples, the cost of commissions and fees have notbeen included.
Trading a Bullish ViewIf you are interested in a particular market and believe prices will go higher, yourdecision is pretty simple with futures, stocks, and many other investment vehicles:You just buy. If the price of the market goes up as you expect, you make money; ifthe price of the market goes down, you lose money. For these instruments it’s astraight-line profit/loss profile (see Figure 9.1).Options give you other ways to invest according to your opinion about risingprices, and most do not involve a simple straight-line profit/loss profile. Let’s consider now a simple buy-call strategy.Buy a Call If you believe a market’s price will go up but wish to avoid the unlimited risk of a futures position, you can buy a call option. Let’s assume you buy acall with a strike price of 100 and pay a premium of 6 points.As the profit/loss diagram illustrates (see Figure 9.2), the advantage of a calloption is that your profit is unlimited while the amount of loss is predefined to theamount of premium you paid for the option. The disadvantage of the call is thatthe price of the underlying market must be higher than 106 for you to make aprofit. Therefore, you must be rather confident in your analysis that the price willexceed 106 prior to the option’s expiration.Let’s plug in and solve the profit or loss of the call-buying strategy for a varietyof different scenarios. Keep in mind that in this example, and for all of theprofit/loss profiles shown, we are calculating the numbers on expiration day. This
152
THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 9.1 Typical nonoptions proﬁt/loss proﬁle. For futures, stocks, and many otherinvestment vehicles, buying is a straight-line proﬁt/loss proﬁle. In this graphic, thepurchase price is 100; above 100 is the proﬁtable zone, and below is the area of loss.
FIGURE 9.2 Buy a call. No matter how much the underlying futures contract drops inprice, the loss will never exceed the cost of the option, in this case $60. Add the optioncost to the strike price to determine the breakeven (6 + 100 = 106 breakeven).
Options on Futures: A Flexible Trading Tool
153
means that time value has dropped to zero and only intrinsic value will be considered. (Remember, though, that you don’t have to hold the option all the way untilexpiration day if a short-term move in the right direction produces enough profitthat you choose to offset the trade.)To review, in our example we bought the 100 strike call for a price of 6. Forsimplicity we’ll say that each point is worth $10, so the cost is $60. We’ll also assume this trade was placed when the underlying futures were trading at 100, sothis was an at-the-money call when it was purchased.Now then, to plug in and solve, simply determine if it is profitable to exercisethe right to buy the futures at the strike price. On expiration day, if the underlyingfutures close at 110, then you can exercise the call (buy the futures) at 100 (thestrike price), which means the option is worth $100 ([110 – 100] × $10/point). Sincewe paid $60 our profit is $40. If the futures close at 106, the option is worth $60, exactly what we paid, so 106 is our breakeven point.Notice that on expiration day if the futures settle at 100, there is no benefitto exercising the call, so the option is worth zero and the trade is a $60 loss (thecost of the option). Finally, on expiration day, at any price below the strike priceof 100, the option is worthless and the trade is a $60 loss. Why is the optionworthless? Because the option provides the right to buy at 100, and at any levelbelow that you can simply go directly into the marketplace and buy the futuresat a better price.Sell a Put When you sell a put, you are not necessarily concluding that pricesare going higher but rather, you just believe prices will not go any lower. This is asubtle but important distinction between option buyers and option sellers. As longas the market price settles above the strike price on expiration, the put will expireworthless and you will keep the entire premium that the put buyer paid you. (Asalways, you can choose to offset your short position at any time and you don’thave to hold it all the way until expiration.)For example, if you sell a 100 strike put for 6, the market would have to closebelow 94 on expiration day for the position to lose money (see Figure 9.3).Let’s plug in and solve for values in this put-selling strategy. On expiration day,if the underlying futures close at 90, the investor who bought the put from you willexercise the put (force you to buy the futures from him or her) at 100 (the strikeprice), which means the option is worth $100 ([100 – 90] × $10/point). Since yousold it for $60, your loss is $40. If the futures close at 94, the option is worth $60,exactly where you sold it, so 94 is your breakeven point.Buying a call and selling a put are both bullish views, but the two strategiesare very different indeed. In the case of selling a put:• Your profit is limited to the premium received. Even if the market rallies to 120or above, the option expires worthless and you get to keep the $60 you collected from the buyer.
154
THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 9.3 Sell a put. The put seller has unlimited loss potential in the event of amarket sell-off and has a ﬁxed maximum proﬁt, in this case the $60 received for selling theput. However, the strategy has a low breakeven (100 – 6 = 94 breakeven) and therefore abetter chance of being proﬁtable.
• Your risk is unlimited should prices fall below the breakeven point. The shortput is just like being long the underlying instrument.• However, the strategy has a lower breakeven (100 – 6 = 94 breakeven) andtherefore a higher probability of being profitable.• Also, time decay works in your favor by eroding the value of the option eachweek.Buy a Call, Sell a Call This is also called a bull call spread or, more generically, a vertical spread. If you think prices are more likely to go a little higher butaren’t convinced they will make a big move, you may not wish to risk buying a callor a futures contract outright. In this type of situation, some options traders like toestablish a bull call spread.For example, with the underlying futures near 100, let’s say you buy the 95 callfor 7 ($70 in our example) and at the same time you sell the 105 call for 3 ($30).You pay out 7 and take in 3, so the net outlay for you is $40 ($70 – $30). Figure 9.4diagrams the results.Let’s plug in and solve for values in this bull call strategy. On expiration day, ifthe underlying futures close at 105, the 95 calls you own are worth 10 (105 – 95)and the 105 calls you sold are worth zero (105 – 105), which means your total
Options on Futures: A Flexible Trading Tool
155
FIGURE 9.4 Bull call spread. Selling a higher-strike call against a call you own limits theupside proﬁt of the trade. The beneﬁt is that you lower your total investment in the trade,lower the breakeven point, and decrease somewhat the effect of time decay.
spread is worth $100 ([10 – 0] × $10/point). Since you paid $40 for the spread, yourprofit is $60. Plug in values for the underlying futures at levels above 105 and youwill discover the most this spread will ever be worth is $100. If the underlying futures settle on expiration day at 95 or lower, both options are worthless and youhave lost the total amount you spent on the spread, in this case $40. Thebreakeven point for this trade is a price in the underlying futures of 99 (95 + 4).The rationale for a bull call spread can be thought of in several ways. If youforecast only a moderate rally then you will be willing to limit the potential profitsof the call you buy by selling a call against it. But even if you believe prices may goquite a bit higher, you may still like the idea of selling the higher-strike call. By doing so, you not only lower your total investment in the trade, but lower yourbreakeven point as well.Or looked at another way, part of what you pay for when you buy a call is thechance the underlying future will rally an unlimited amount. But as a practicalmatter, some level of profit exists where you will choose to offset the trade. Forsome, that may be a relatively small profit and for others it may be quite large,but what is the chance someone will hold a call to infinity? If you know in advance you will be offsetting the position on a rally to some level, why pay forthat portion of the call that represents the profit area you won’t participate in
156
THE COMPLETE GUIDE TO FUTURES TRADING
anyway? By selling the higher-strike call, you are simply selling back thoserights (to the higher portion of the move) to another and helping to pay for theoption you are buying.Another more obvious benefit is gained in a bull call spread as well. Selling ahigher-strike call not only lowers the cost of the trade, it provides some protectionagainst time decay, too. Time decay erodes the value of the call you own but alsothe call you sold. Of course, the net position will still experience some time decay,but the sell side of the trade can provide significant relief. The next strategy is avariation on the bull call spread that actually benefits from time decay.Buy a Futures Contract, Sell a Call Also called a covered call or a synthetic short put, this is a variation on the bull call spread. Instead of owning acall and then hedging with a short call, the covered call strategy starts first witha long futures position and sells a call against that. The covered call is a wellknown stock option strategy often presented as a method of generating incomeon an existing bullish position. This is because the investor receives money forselling the call. Of course, this is in exchange for limiting the potential upside ofthe trade.Basically, with this strategy you are bullish the underlying futures but areagreeing in advance to sell the position at the strike price in the event of a rally.Just as with the bull call spread, selling a call lowers the breakeven point of thetrade. Equally important is the fact that because the buy side of the trade (the futures) is not a wasting asset, time decay works in your favor by eroding each weekthe value of the call option you sold.The profit/loss diagram of this strategy looks identical to the short put strategyshown in Figure 9.3—limited upside profit, unlimited downside risk, and a lowerbreakeven. One reason to use this covered call strategy instead of a simple shortput is the ability to leg into or to leg out of the trade. For instance, an investor whowas originally long the futures during a rally may wish to then sell a call againstthe position. By waiting for the rally, he or she may be able to sell the call at ahigher price.
Trading a Bearish ViewIf you believe market prices are headed lower, your decision again is pretty simplewith futures, stocks, or many other investment vehicles: You just sell. If the priceof the market goes down as you expect, you make money; if the price of the market goes up, you lose money. The profit/loss profile of a short position in futures isa straight-line projection (see Figure 9.5).Buy a Put All things being equal, a put will increase in value as the underlying futures market drops. If the market price collapses, your profit potentialis unlimited.
Options on Futures: A Flexible Trading Tool
157
FIGURE 9.5 Proﬁt/loss proﬁle of a typical nonoptions bearish trade. For futures, stocks,and many other investment vehicles, selling short is a straight-line proﬁt/loss proﬁle. Inthis graphic, the market is sold short at 100; below 100 is the proﬁtable zone and above isthe area of loss.
Let’s plug in and solve the profit or loss of the put-buying strategy shownin Figure 9.6, where the purchase is $60. Again, all figures are calculated onexpiration day, which means that time value is zero and only intrinsic value isconsidered.If the underlying futures close at 90, then you can exercise the put (sell the futures) at 100 (the strike price), which means the option is worth $100 ([100 – 90] ×$10/point). Since we paid $60 our profit is $40. If the futures closed at 94, the option is worth $60 ([100 – 94] × $10/point), exactly what we paid, so 94 is ourbreakeven point.Sell a Call When you sell a call, you are not necessarily positioning for pricesto go down, but rather, you just believe prices will not go any higher. As long as themarket price stays below the strike price at expiration, your profit is the premiumthat the call buyer paid. In the example, if you sell a 100 strike call for 3, the market would have to close above 103 on expiration day for the position to losemoney (see Figure 9.7).Let’s plug in and solve for values in this call-selling strategy. On expiration day,if the underlying futures close at 105, the investor who bought the call from you
158
THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 9.6 Buy a put. All things being equal, a put will increase in value as theunderlying futures market drops. The loss on this trade will never exceed the cost of theput, in this case $60. Subtract the option cost from the strike price to determine thebreakeven (100 – 6 = 94 breakeven).
will exercise the call (force you to sell the futures to him or her) at 100 (the strikeprice), which means the option is worth $50 ([105 – 100] × $10/point). Since yousold it for $30, your loss is $20. If the futures closed at 103, the option is worth $30,exactly