Options 101
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A Futures Refresher...
Futures contracts are standardized exchange traded forward contracts on commodities – either tangible goods such as corn or crude oil or financial instruments such as Treasury bonds or currencies. The exchanges which house the trading of these contracts are designated by the Commodity Futures Trading Commission, a congressionally anointed organization which regulates commodity futures trading. Futures contracts can be bought or sold on these exchanges through clearinghouses, organized entities who guarantee performance.
While many market participants are industry producers and end users who are hedging against future price change, liquidity is brought by the majority of traders – the speculators. A speculator is a trader who assumes the risk associated with buying (going long) or selling (going short) a contract in the hopes that they can offset (sell if they are long, buy if they are short) their position at a later time for a profit.
Options are just that. Options.
Just as futures contracts are derivatives of actual commodities, options are derivatives of futures contracts. An option is a contract which entitles the buyer to take a particular action on a futures contract at a specified price – the strike price. In the case of a call option, the buyer has a right to purchase the underlying futures contract at the specified strike price. For a put option, they have the right to sell the underlying futures at the strike price.
The contract does not oblige the purchaser to act, it just gives them the choice. The choice to initiate action is referred to as “exercising” the option. For American-style options contract, the type most common in North American exchanges, exercising can take place at any time over the life of the option. For most people, this would only be done when an option is “in-the-money”. An option is in-the-money when the strike price results in a futures position which could be immediately offset for a profit if exercised. A call would be in-the-money if the strike price is below the current futures price. A put option would be in-the-money if the strike price is above the current futures price.
An option can also be at-the-money (the strike price is the same as the current futures price) or out-of-the-money (the resulting futures price would not result in a profit if exercised.
These contracts may sound too good to be true and the fine print to an option is that you pay a price for the choice. The price of an option is known as “premium”. Pricing can fluctuate based on a number of factors. The first is intrinsic value – in-the-money options have intrinsic value and are therefore more expensive than in- or out-of-the-money options.
Options also have time value, the length of time left until they expire All options have a time limit expressed as a date on which they are no longer valid. An option which has several months rather than several weeks until expiration will have a higher premium since it has more time for the underlying futures to trade at or through the strike price thereby increasing the intrinsic value.
Markets which have large price movements can also have more expensive options. The potential for large price swings is known as volatility and since these options have more uncertainty behind them, the premium is higher.
All of the factors which influence option price can be explored further with the Greeks, mathematical formulas which show each of the aforementioned items. More information on the Greeks can be found on this website if you would like to learn more.
Why trade options?
Many traders who buy options do so because of their defined risk. Since options are not automatically exercised if they are at- or out-of-the-money, the maximum loss for an option is the amount paid when the position is initiated. If the option is not in-the-money at expiration, it expires worthless.
This gives traders the opportunity to play a directional view of a market without having to put up margin (a performance bond) or be required to make additional deposits if their view is wrong.
Some people choose to be option writers, which is a different scenario. An option writer – or seller – does not have the same choice as a buyer. A seller collects premium for the option and has to assume the opposite position if the option is in-the-money and exercised. The option seller’s risk is unlimited and does require a performance bond deposit that may increase if the position goes against them. The maximum profit is the premium collected.
Like futures, options trading is not limited to simply buying or selling one contract and many of the same spread techniques used in futures contracts can be implemented for options. There are strategies which can include buying and simultaneously selling options. For more on different trading strategies, please visit our higher learning pages.
