be exercised. The option’s value rises or falls based on the proximity between the fixedstrike price and the current market value of the futures contract (orfund value). The expiration date is the last of these basic terms.That is the date by which the option has to be exercised or closed. Ifthe open option remains open until after expiration, it immediatelybecomes worthless.The strike price of every option is a fixed value for the underlying security. In other words, if a buyer exercises the option (or ifits seller experiences exercise) it must occur at the strike price. Ifthe value of the underlying security rises, the value of calls will risetoo; and the value of puts will fall. If the value of the underlyingsecurity falls, the value of calls will fall too; and the value of putswill rise. Although the increase or decrease in value is based onwhat would occur if the option were exercised, the majority of options buyers are more likely to sell the appreciated option at aprofit. So the profit is made in the net difference between purchaseand sell prices. If the trader goes short, the profit occurs in a reverse sequence: sell, hold, and buy. For example, if you open ashort option position at 4, you are paid at the time the ‘‘sell toopen’’ order is placed. You are paid $400. Later, when the option’svalue has diminished to $100, for example, you close it out by entering a ‘‘buy to close’’ order. You pay $100 and realize a profit of$300. As a seller, you can also just let the short position expire, andrealize the entire $400 as profit. Of course, the risks of going shorton options are considerable. So even though the profit potential isconsiderable for option short sellers, so is the risk.All options expire in the future. Traditional listed options lastonly a few months, and Long-Term Equity AnticiPation Securities(LEAPS) options last up to 30 months. However, options on futures contracts are more limited than those on stocks. Shares ofstock are going to last for many years, so no stock-based expirationor delivery date is at issue. However, futures contracts all expirewithin a few months. Thus, options on futures contracts cannotlast longer than the contracts themselves.This leads to an oddity you do not see in stock-based options,where there is only one class of common stock on which options
The Leveraged Approach: Options on Futures
127
can be written. Options on futures contracts are essentially contracts on contracts. Futures are written on underlying commodities, and options are written on futures contracts. So you maydiscover that futures indices and ETFs will have a large number ofoptions, all short-term. For example, the GSCI index as of January2008 has more than 80 current options available, expiring betweenJanuary and July, or between one week and six months. Even morevolume of activity is found in the oil ETF, United States Oil Fund(USO). This ETF offers more than 360 current options, expiringwithin one week and six months.There tend to be far fewer stock-based options because withstocks, option strike prices are normally occurring at 5-point intervals. (For lower-priced stocks, 21/2 point intervals are also available, and for stocks trading above $100 per share, the intervalmoves up to 10 points.) In comparison, both of the commoditybased options (GSG and USO) trade in 1-point increments. GSGclosed on the sample day at $52.65 per share, and options wereactive with strike prices between $39 and $55. The USO was evenmore active. On the same day, it closed at $73.09 and options wereactive between expiration of one week and six months, with strikeprices between $40 and $105.The variety and flexibility of option strikes and expiration datestranslates to a larger number of option alternatives and strategies.In addition, the risk level is entirely up to the option trader. Goinglong—buying calls if you think the share price is going to rise orbuying puts if you think it will decline—is a reasonably safe formof speculation. The most you can lose is the premium cost of eachoption. In comparison, going short, i.e., selling calls if you thinkthe price is going to fall or selling puts if you think the price isgoing to rise, involves much greater risk. Short sellers can lose alot of money if the index of ETF goes in the direction opposite ofthe short seller’s estimate. The loss is somewhat mitigated, becauseshort sellers receive the premium when the option is sold. However,exercise can be expensive if the index price moves significantlyaway from the strike price. For example, if you sold a July 2008 54call on GSG, you would receive $462 based on the last price. Butif the share price rose 10 points above that level by July, the callwould be exercised, and you would be required to deliver 100
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shares of GSG at $54 per share, even though market value was$64. This loss of $10 per share ($1,000) minus the original callsales price of $462 translates to a net loss of $538 (plus transactionfees on both sides of the trade).The risk levels of futures on options are significant becausetraders have to be aware of not only profit potential but also of losspotential. Speculating on futures contracts can be expensive, eventhrough an ETF. However, options enable you to control shares ofa tracking index of ETF for a small fraction of the share price. Inthe previous example, you could trade a single option for under$500 while controlling 100 shares that would cost $5,265 to purchase without the use of options. So the leveraging feature of options is very attractive.However, before determining whether a particular option is agood bargain or not, you also have to analyze the proximity ofstrike price to current market value.
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Valuation of OptionsWhen you look at option listings, you find a range of current values. Table 8-1 summarizes the closing option listings for a portionof GSG on January 11, 2008.First, remember that each option controls or relates to 100shares of stock in the underlying security. In this example, all theApril calls and puts are listed. GSG closed on the day at $52.65,and most of the call and put action take place on the 53 contracts.The ‘‘53’’ is the strike price, and the open interest (the number ofactive contracts) is highest because this is the closest strike price tothe current market value of GSG.The ‘‘last’’ column shows the last price at which each optionwas traded. In those instances where last is quite different than thebid and ask, it usually means no trades have occurred recently.Check the April 47 call, which had no trading and no open interest,a zero value in the last, and relatively high bid and ask values.A ‘‘bid’’ is the price at which the option was most recently sold,and an ‘‘ask’’ is the latest price at which it was bought. The difference, called the spread, represents the profit the floor trader, market maker, or specialist earns for executing a trade.
Calls
Last
Bid
Ask
Volume
OpenInterest
Puts
Last
Bid
Ask
Volume
OpenInterest
APR46 08APR47 08APR48 08APR49 08APR50 08APR53 08APR55 08
7.5006.205.204.302.602.35
7.006.205.404.704.002.351.60
7.506.705.905.104.402.751.85
30000200
103811212271
APR46 08APR47 08APR48 08APR49 08APR50 08APR53 08APR55 08
01.001.602.401.203.504.40
3.500.450.650.901.202.453.60
0.500.650.851.101.402.804.00
0000000
05344101
The Leveraged Approach: Options on Futures
TAB L E 8 . 1 . i S H A R E S S & P G S C I C O M M O D I T Y I N D E X E D O P T I O N L I S T I N G SGSG—$52.65 —1/11/08
129
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‘‘Volume’’ is the number of trades made during the reportedsession. And ‘‘open interest’’ is the number of active, open optioncontracts at the end of the day.By looking over the range of latest prices for each strike pricein an option, you can judge relative value. The value is going tovary by two factors. First is proximity between current market valueand the option’s strike price. For example, the April 53 call is quiteclose to the current market value of GSG of $52.65; and the April46 is many points below. The second factor affecting the option’spremium value is the time left until expiration. In this case, the Apriloptions had three months to go before the April expiration. TheApril 53 call last traded at 2.60 (this abbreviation translates to$260). But if you check the January 53 call, set to expire in onlyone week from the January 11 date, it was trading at only 0.40($40).This difference consists of time value, or the degree of an option’s premium that can be assigned to the time remaining untilexpiration. If it were possible to isolate time value alone, you wouldsee it decline at an accelerating rate as the expiration date approaches. Figure 8-2 summarizes this trend in time value.As you might expect, time value is only part of the overall premium value in an option. There is also intrinsic value. This is theportion of a call when current market value of the underlying security is higher than the strike price, or the portion of a put whencurrent market value of the underlying security is lower than thestrike price. For example, GSG’s current market value in the example was $52.65. The April 53 call contained no intrinsic value, butthe April 50 was reported at 4.30 ($430). Of this, 2.65 points wereintrinsic value and the remaining 1.65 points were time value:Intrinsic valueTime valueTotal premium
$265165$430
All the calls shown above the current market value had no intrinsic value, and their entire premium consisted of time value. Theput is opposite. So when a put’s value is higher than current marketvalue, it contains some intrinsic value. The 50 put has no intrinsic
131
The Leveraged Approach: Options on FuturesFIGURE 8.2. TIME VA LUE PREMIUM
OPTIONVALUE
value atpurchase
expiration
T I M E
value, but the April 53 put (worth 3.50, or $350) was 0.35 abovecurrent market value of GSG, so its intrinsic value was $35:Intrinsic valueTime valueTotal premium
$ 35315$350
The distinction of a call’s being above or below the strike priceis defined as being ‘‘in the money’’ (current market value of theunderlying security is higher than a call’s strike or lower than aput’s strike); out of the money (current market value of the underlying security is lower than a call strike or higher than a put strike);or at the money, which occurs when the current market value ofthe underlying security is exactly the same as the strike price of theoption.Figure 8-3 summarizes the comparative relationship of the underlying security to call or put strike prices.The option premium contains a combination of intrinsic andtime value, and no intrinsic value exists when at the money or outof the money. However, time value premium often acts in a volatile
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F I G U R E 8 . 3 . I N T R I N S I C VA L U E
PRICE
calls in the moneyand puts out ofthe money
INTRINSIC VALUE (calls)strike price
INTRINSICVALUE(puts)
puts in the moneyand calls out ofthe money
manner, rising or falling to a higher or lower degree than youwould expect in a predictable world. This aspect of option valuation, usually lumped in as a part of time value, is actually quitedistinct. It could be called ‘‘volatility premium,’’ because it variesbased on interest in both the underlying security and the optioncontract itself. It is also called extrinsic value. This is the portion ofpremium that makes any option trading uncertain, because it cannot be predicted. If you isolate pure time value, the course of erosion is fairly predictable based on time, and the rate of accelerationis also predictable. Intrinsic value is also quite simple to compute.Each dollar of in the money in the underlying security translates toone dollar of intrinsic premium value in the option. To the extentthat option premium values vary from these predictable models, itrepresents the volatility of the contract and underlying security.
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Strategy Basics: An OverviewFinding the best option trading strategy involves testing your ownassumptions and risk tolerance levels. If you are going to tradeoptions on futures, either directly or through a pooled index or
The Leveraged Approach: Options on Futures
133
ETF, you first need to make sure that the decision is a good matchfor you. A five-part analysis helps make this decision.1. Master terminology and trading rules. The most difficult part ofoptions is learning the language, which involves a lot of jargon.Each definition contains important distinguishing features of option trading and the risks involved; in addition, you need to getapproved by your brokerage firm to even trade options. As part ofthe approval process, your broker assigns a trading level based onyour knowledge and experience as well as the dollar size of youraccount. Getting through this first step can be daunting, because itappears complex at first. However, once you get over the initialhurdle, you will find options to be an excellent addition to a rangeof strategies within your portfolio.2. Identify risk tolerance limits. Next, you need to understand exactly what kinds of risks you can afford to take and are willing totake. Not everyone can tolerate the same level of risk. This decisionis based on income, size of your portfolio, and experience as atrader and investor. You need to carefully and completely defineyour risk tolerance level before making any decisions.3. Match risk tolerance to strategies. There are many possible option strategies to choose from. The mere decision of using futuresbased pools as a vehicle for options is itself the result of analyzingyour risk tolerance level and concluding that these options are asound way to proceed. Some strategies are conservative, othersvery high risk. So you need to ensure that you are in control of riskby the kinds of option-based strategies you decide to pursue.4. Identify your trading goal. Some traders use options to insurelong positions. This hedge involves holding long puts so that, in theevent the underlying security loses value, that loss will be offset byhigher value in the puts. Others use options to swing trade, buyingcalls or selling puts at price dips, and doing the opposite whenprices climb to high levels. In between these examples of the strategic uses of options there is a range of many other possibilities.5. Find a good match between strategy, risk, and goal. The ultimatepurpose in analyzing options is to decide whether you will be ableto find a strategy that is also a solid match for your own risk toler-
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ance, and that will help you achieve your goal. That goal can beshort-term cash profits, insurance, hedging, or pure speculation.As long as you know in advance what you want to achieve, youhave a good chance of finding the best strategy, or deciding thatoptions are not a good fit for you.There are a few basic strategies everyone should know. Beginning with long positions, remember that as the owner of an option,you are never required to exercise. You can exercise if you want,sell at any time, or allow the option to expire worthless. In the longposition, you have all the control and you decide when and if tomake a decision.Buying calls is the most popular basic option strategy. Calls aremore popular than puts because most people think that commodityprices are going to rise. Buying puts only works if prices fall, soputs are more easily overlooked. But even call buyers face a difficulttask in trying to profit consistently from speculating in options.About three-quarters of all options expire worthless, meaning thereis only a one-in-four chance that you will make a profit from buyingcalls. Even so, most speculators believe they can beat the odds.For example, Table 8-2 summarizes five listings for the U.S.Oil Fund as of the close of business on January 11, 2008.The day’s close for USO was $73.09, so the 73 calls and thoseabove that level were slightly out of the money; and those callshigher than that level were also out of the money. Thus, they represent a range of calls of substantial interest to option traders. Inaddition, there were six months to go until expiration, which is anattractive range. Given that USO closed at $73.09, the July 73 callswere attractive, especially to those believing that the price of oil wasgoing to rise.Buying puts works in reverse. The put increases in value whenthe market value of the underlying security falls. The more it falls,the more valuable the put becomes. So if you believe a commodityis overpriced and that it will retreat in the near future, long putsmay be the way to go. For example, referring back to Table 8-2, allthe listed puts were in the money. (Remember, puts work in reverseorder from calls, so when the put strikes are higher than currentmarket value, they are in the money.) In this situation, the July 73
Calls
Last
Bid
Ask
Volume
OpenInterest
Puts
Last
Bid
Ask
Volume
OpenInterest
JUL73 08JUL74 08JUL75 08JUL76 08JUL77 08
6.607.935.506.105.10
6.205.705.305.004.60
6.606.205.705.405.00
110402
1378112011383
JUL73 08JUL74 08JUL75 08JUL76 08JUL77 08
6.305.807.606.606.80
6.206.707.307.908.50
6.607.107.708.309.00
001600
160141294143120
The Leveraged Approach: Options on Futures
TAB L E 8 . 2 . U N I T E D S TAT E S O I L F U N D O P T I O N S L I S T I N G SUSO—$73.09 —1/11/08
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put is only slightly in the money. So if you believed that oil priceswere going to fall in the coming six months, this would have beena play worth considering. Because the July 73 put is in the money,intrinsic value will increase point for point with a decline in USO(although that may also be offset by declining time value during thesame period).Buyers of options face a problem in picking the right option,whether calls or puts. No matter which option you select, the longerthe time until expiration, the higher the cost is going to be. It isdesirable to have more time rather than less, because you need timefor the underlying security to rise enough to produce a profit. Additionally, the most promising options are those close to the strikeprice; but these will be more expensive than those further out of themoney. If you look only for bargain-priced options, you have asmaller chance of making a profit.The option has to increase enough in value to cover your initialcost and to grow in intrinsic value before expiration. So if you pay5 ($500) for a call that will expire in six months and it is at themoney, you will need that commodity to rise five points just tobreak even. That has to occur before expiration. If you pay 4($400) for a put that is at the money and has four months to gountil expiration, you will need the commodity to fall four points justto break even, and that has to happen within the next four months.The basic long strategies for option trading are not high risk.The most you can lose is the price you pay for the option. In comparison, the short side of option trades may contain much greaterrisks. So even though potential losses are limited in long positions,remember that there is only about a one-in-four chance that youwill make a profit.Traders use long calls and puts for many reasons. Some arejust speculating in the short-term roller coaster of play variance,while others are attempting to take advantage of short-term pricedips, protect paper profits, or take profits without selling commodities through small but consistent option profits.
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Advanced StrategiesThe speculative long call and put is perhaps the most popular option strategy. It is simple, losses are limited, and traders enjoy tell-
The Leveraged Approach: Options on Futures
137
ing their friends how they doubled their money in only three days.(Of course, they forget to also mention that that happened onlyonce in four attempts.)Another variation of option strategies is the short position. Inthe futures market, you will probably want to avoid shorting thefutures contract directly because it could involve significant risks.However, with the use of options, those risks can be reduced. Youcan write short calls in one of two ways. First is the naked shortcall. This occurs when you do not own shares of the underlyingsecurity. Believing that the price of USO is going to fall, for example, you may decide to sell a July 74 call. Referring back to Table8-2, note that this call was exceptionally rich (meaning higher thansurrounding options), closing at 7.93 ($793). This is somewhatmisleading, however. Note that the bid/ask spread was 5.70 to6.20, much lower; and that no trading occurred on that day. So ifyou were to sell this call, you would probably receive a much lowerpremium. This short call remains attractive, however, if you arewilling to take the naked call risk.When you sell an option, the premium amount is placed intoyour account when the trade is complete. Your brokerage firm willimpose margin requirements when you sell naked options, and youalso have to be qualified to trade at an acceptable position to beallowed to write naked options. As long as the underlying security’smarket value falls, you will make a profit. If the option expires outof the money, you keep the entire amount; or you can enter a ‘‘buyto close’’ order once the call’s value has declined, pay the currentvalue and book a profit on the position.The risk is that the short call could be exercised. This can occurat any time before expiration when the call is in the money, although it is most likely right before expiration. In the event of exercise, you would be required to purchase 100 shares of USO atcurrent market value, and then deliver it at the strike value. Forexample, if you sold a July 74 call and it was exercised (called) at apoint when USO had gone to $80 per share, you would lose $600.Your actual loss would be reduced by the amount of call premiumreceived at the time you opened the short call. For example, if youreceived 5, your net loss on this trade would be $300 (eight points
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Reaching the Market
for the difference between market value and strike, less five pointsyou were paid when you sold the call).The risk of the naked, or uncovered, call is too great for mosttraders. In comparison, you can also sell a covered call, which isprobably the most conservative strategy possible. In this case, youown 100 shares of the underlying security for each call you sell. Inthis example, you might have bought 100 shares of USO at $68per share. If you sell a covered call for July at strike of 74, youwould profit in two ways. First, you keep the call premium you arepaid; second, you earn a capital gain on the investment of $600(strike of $74 per share minus your basis of $68).You can also sell puts, although it is not possible to create a‘‘covered’’ put in the same way you can create a covered call. However, the risks of a short put are far less than those for an uncoveredcall. While the underlying security’s market value can rise indefinitely, at least in theory, it can only fall so far. In the worst case, itcould fall to zero, but that would mean the components of the poolwould also have to lose all value. That is not likely to happen in anyscenario. For example, if you were to write a put on USO, you canestimate the maximum risk by calculating the potential lowest pointto which the component futures contracts could fall. So if oil wasat about $98 per barrel in the beginning of January 2008, whatwere the odds of the price falling within six months to $90, $80, or$70?The point is that putting aside the theory for the moment, therealistic range of likely market risk is quite small in writing putsagainst pooled futures indices or ETFs. You benefit from the diversified portfolio as well as from the realistic range of likely pricemovements in the futures contracts.For example, if you had sold a July 73 put in the beginning ofJanuary 2008, the premium somewhere between $620 and $660would be placed in your account. If you believe oil prices were likelyto rise, this would be a worthwhile form of speculation. USO closedat $73.09; so as long as prices remained above $73, exercise wouldnot occur. If the USO market value fell even six points, your putpremium income would create a small profit or break even. If theUSO market value fell lower than $67 per share, you would lose.Short option positions can be rolled forward in the same way
The Leveraged Approach: Options on Futures
139
that futures contract holdings are rolled forward. When expirationnears, short option positions in the money can be closed and replaced with later-expiring contracts. This can be accomplished atthe same strike or a different one. For example, let’s say you hadsold a naked call expiring in January 2008 at 70. Just before expiration, on January 11, that contract closed at 3.20 ($320). If youtook no action, it would be exercised, since USO was at $73.09per share; the option was three points in the money. To avoid exercise, you could ‘‘buy to close’’ the January 70 and replace it. Youhave several choices. The February 70 call closed at 4.50, so youcould roll into that position and realize $130 profit (minus transaction fees). This not only creates additional profit; it also avoids ordelays likely exercise. But it leaves your open position in the money.You could also replace the January call with an April 74, whichclosed at 4.30 ($430). This yields $110 and leaves you in a shortposition for three more months. However, it replaces the about-toexpire short call with another call out of the money.Since in-the-money puts move in the opposite position, youwould want to roll a short in-the-money put forward to avoid exercise, or forward and down to a new strike. For example, if you hadsold a January 75, you would face imminent exercise. So to avoidthis, you could buy to close the January 75 put (which closed at2.55) and replace it with a February 75 put (which closed at 4.10),and realize a profit of $155 while also putting off the likely exercise.(Remember, in-the-money options can be exercised at any time,but the most likely timing is right before expiration.) Another alternative would be to replace the January 75 and replace it with anApril 72 put. That closed at 4.10, so you would realize the sameprofit as with a February 75 replacement. However, you commityourself to three more months while lowering the likely strike priceand taking the short position out of the money.Rolling grants you substantial flexibility to avoid exercise ofshort positions. In both USO and GSG, for example, option contracts occur in one-dollar increments. At the same price levels forstocks, options would only be available in five-point increments. Inmany instances, this gap makes it more difficult to produce netcredit in rolling without going out more months, or without beingable to pick the strike level you desire.
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You can roll both naked and covered calls to avoid exercise, aswell as short puts. As long as you avoid exercise and produce additional profits, rolling is effective as a means for also adding futureprofits to your position. Even if eventually exercised, the rolled option will produce higher capital gains. For example, if you replacea current 70 call with a later-expiring 74 call, if and when that isexercised, you earn $400 more in capital gains. And if you roll aput down from 75 to 72, upon exercise you gain an additional $300capital gain, or reduce a capital loss by $300. For many optiontraders, exercise will be a rare event. By remaining diligent in tracking short positions to avoid exercise, you will be able to avoid goingin the money on a majority of open short positions, continuallyrolling forward and up (for short calls) or forward and down (forshort puts).
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Combining OptionsSo far, the strategies explained have been limited to the use of single options. You can go long a call or a put, or go short a call ora put. Using multiple contracts increases both risk exposure andpotential profit. When writing covered calls, owning multiple increments of 100 shares of an underlying security also increases thepotential strategies. For example, you can write a range of differentcovered calls involving various strikes and expirations. You can alsouse ratio writes, which mitigate risks of uncovered call writingwhile augmenting income. For example, if you own 400 shares andwrite five calls, you have a five-to-four ratio write.There is more to the possible strategic uses of options for futures investing. The use of options becomes truly interesting whenyou move into the more advanced realm of spreads and straddles.A spread is a strategy in which you buy and sell options onthe same underlying security at the same time, but with differentexpiration, strike, or both. You can accomplish a spread by buyingor selling, and using either calls or puts. For example, a bull callspread is designed to produce profits when the underlying securityrises in value. You buy a call at one strike and sell a call at another,higher strike. For example, referring to Table 8-2, you may buy aUSO July 75 call and sell a July 76. The net difference between
The Leveraged Approach: Options on Futures
141
these two is only $60, so you receive that amount for opening thespread. If the USO market value remains below $75 per share, theposition would expire worthless and you keep the $60 difference.If the market value rose above the $76-per-share level, the shortcall could be exercised, but the long position would protect all but$100 of that position. In that outcome, you could roll the short 76call forward to avoid exercise and sell the 75, either at a profit or(if time value evaporated) at a loss. The risk in the long bull spreadis minimal, but so is the potential profit.A bear spread involves the same basic approach, but using longputs. For example, in the case of USO, you could have bought aJuly 74, which closed at 5.80 on January 11; and sold a July 73,which closed at 6.30. Your net income in this situation