An option on a futures contract is just like an option on anything else such as an individual stock. The only difference is that, with options on futures, the underlying interest is a futures contract. For instance, a May option on frozen concentrated orange juice (FCOJ) has as its underlying interest one May FCOJ futures contract.
Call and Put Options
A call option gives the holder the right, but not the obligation, to buy the underlying interest at a known price which is the strike price of the option at or prior to option expiration. To buy an option costs money and this cost is referred to as the option premium. The holder can effect the purchase of the underlying interest by exercising the option. For example, a June Euro call option having a strike price of $0.6355 might cost $350. Anyone willing to pay $350 - the option premium - can acquire this option which will give the holder the right to buy one June Euro futures contract at a price of $0.6355 on or prior to the option's expiration. For every option buyer, there is an option seller. The seller of a call option receives the option premium but, in return, must sell the underlying interest to the option holder if the holder exercises the option. As the price of the underlying interest rises, a call option increases in value. This accrues as a gain to the option buyer and a liability to the option seller.
A put option gives the holder the right, but not the obligation, to sell the underlying interest at a known price which is the strike price of the option at or prior to option expiration. The option buyer pays the option premium. The holder can effect the sale of the underlying interest by exercising the option. For example, a June Euro put option having a strike price of $0.6395 might cost $475. Anyone willing to pay $475 - the option premium - can acquire this option which will give the holder the right to sell one June Euro futures contract at a price of $0.6395 on or prior to the option's expiration. For every option buyer, there is an option seller. The seller of a put option receives the option premium but, in return, must buy the underlying interest from the option holder if the holder exercises the option. As the price of the underlying interest falls, a put option increases in value. This accrues as a gain to the option buyer and a liability to the option seller.
Quoting Option Prices
In the option trading pit and in newspapers, option prices are quoted in terms of ticks, or minimum price fluctuations, and not the full price in dollars and cents. To determine the actual dollar cost of an option, you need to multiply the market price in ticks by the dollar value of a tick. (The tick value of an option is almost always the same as the tick value of the futures. This is determined by the futures exchange and detailed in the option contract specifications.) For instance, consider the example above of a June Euro call option having a strike price of $0.6355. The price of this option might be quoted as $0.0028, or .28 cents, or just 28, which means 28 ticks. Each tick of a Euro options contract (as well as a futures contract) has value of $12.50. Therefore, the dollar price of this option is 28x$12.50 = $350.
Valuing Call and Put Options
Call and put option premiums depend upon several factors, the most important of which is the strike price of the option relative to the market price of the underlying futures contract. A call option becomes more valuable, and hence the premium becomes greater, as the market price of the underlying futures contract rises above the option's strike price. Consider the example above of a June Euro call option having a strike price of $0.6355. If the market price of a June Euro futures contract is $0.6295, then this option will have little value: Why pay for the privilege of buying the futures at $0.6355 when you can alternatively buy the futures now in the market at a lower price? Say, though, that the market price of a June Euro futures is $0.6385. Now, the option should have value because, if you own it, you can purchase the futures at $0.6355 which is below the market price. In fact, this option will cost at least $0.0030 (having dollar value of $375), which is the difference between the strike price of the option and the market price of the underlying futures contract and is referred to as the intrinsic value of the option. The option will likely trade at a price above its intrinsic value, say, $0.0041 (having dollar value of $512.50). The amount by which an option trades above its intrinsic value is referred to as the option's time value. In this case, the time value is 11 ticks having value of $137.50.
A put option becomes more valuable, and hence the premium becomes greater, as the market price of the underlying futures contract falls below the option's strike price. Consider again the example of a June Euro put option having a strike price of $0.6395. If the market price of a June Euro futures contract is $0.6430, then this option will have little value: Why pay for the privilege of selling the futures at $0.6395 when you can alternatively sell the futures now in the market at a higher price? Say, though, that the market price of a June Euro futures is $0.6340. Now, the option should have value because, if you own it, you can sell the futures at $0.6395 which is above the market price. In fact, this option will cost at least $0.0055 (having dollar value of $687.50), which is the difference between the strike price of the option and the market price of the underlying futures contract - the intrinsic value of the option. The option will likely trade at a price above its intrinsic value, say, $0.0065 (having dollar value of $812.50). Again, the amount by which an option trades above its intrinsic value is referred to as the option's time value. In this case, the time value is 10 ticks having dollar value of $125.
The intrinsic value and time value together constitute the option premium. An option may or may not have intrinsic value, but it will almost always have time value. Any option may become valuable in the future and hence, a liability to the seller, so the time value exists to compensate option sellers appropriately. The major factors that influence the time value of an option are:
Time of Expiration: The longer the time to expiration of a call or put option, the larger the time value. This is because, with lots of time until expiration, the option has plenty of opportunity to acquire intrinsic value. On the flip side, as an option approaches expiration, the time value, all else constant, will erode steadily to zero.
Volatility: As the underlying futures contract becomes more volatile, the time value of a call and a put option increase. This is because, as volatility rises, it becomes more likely that prices will move to the point where the option has intrinsic value.
Options as an Investment
Option prices fluctuate. Just like with futures, money is made if you buy an option and later sell it at a higher price, or sell an option and later buy it back at a lower price. Options have some attributes, though, that make them different than futures as an investment and, for some traders, preferable.
Limited Downside Risk: Buyers of options, whether a call or a put, have limited downside risk: The most that they can lose is the premium paid for the option, plus commissions. If prices move adversely after option purchase, the holder will simply let the option expire worthless (without exercising it). Buyers of a futures contract, on the other hand, have no such protection. If prices move adversely after the futures purchase, the holder suffers all losses until the position is closed. While option buyers have limited downside risk, option sellers do not since an option seller must enter into a transaction at the discretion of the option holder, no matter how adversely prices have moved. For this reason, selling options is considered riskier than buying options.
Option Expirations: Options are either exercised or allowed to expire worthless. Options will only be exercised if it is in the financial interests of the holder to do so. If an option is left to expire worthless, it is the option seller who benefits as they were able to earn the full premium of the option that was received when the option was sold. An option that expires worthless also enables the option seller to get out of his short option position without having to initiate an offsetting transaction. By contrast, a seller of a futures contract can only get out of this position by offsetting it with another transaction, or actually making delivery of the underlying interest.
No Margin Calls: Buyers of options must pay the full amount of the option premium upon purchase. Since full value has been paid, the option buyer will never face a margin call on a long option position, no matter how much prices move adversely. In contrast, buyers of a futures contract may be required to deposit more margin if prices move adversely. Seller of options do not have this benefit and may be required to deposit additional margin if prices move adversely.
No Price Limits: Markets for options on futures typically do not have price limits, even if the futures market operates with price limits. As a result, an option trader will not face a "locked-limit" market.
Variety of Strike Prices: Options are listed with a variety of strike prices, usually selected to straddle the market price of the underlying futures contract. Because strike prices differ, the premium of these options will also differ - some will be more expensive than others. This provides a lot of flexibility to the option trader. For instance, the call option buyer who is willing to risk only a small amount of money can buy a call option with a high strike price as it will have a relatively low premium.
Selling Options
Selling options, whether calls or puts, is riskier than buying options since the downside risk (or potential loss) is similar to that of an outright futures position. For this reason, option sellers must deposit margin just like for a futures transaction, and may be required to deposit additional margin if prices move adversely. Beginning traders should be very cautious when considering the sale of an option.
Option sales can be covered or uncovered. An call option sale is covered if the seller owns the futures underlying the option. For instance, the seller of a COMEX December gold call option is covered if they also own or are long December gold futures. Alternatively, if the call option seller does not own the underlying futures, then the sale is uncovered or naked. Uncovered option sales are riskier than covered option sales since in the former, the option seller must enter the market to acquire the underlying futures if the option is exercised, and thus faces this price risk. The covered seller, in contrast, already owns the underlying futures and does not face this price risk. A put option sale is covered if the seller is already short the underlying futures, and uncovered is the seller has no such position in the underlying futures. Again, an uncovered sale is riskier than a covered sale.
Offsetting Contracts - Just like with futures, an option position can be offset by entering an equal but opposite trade - for example, buying if you previously sold or selling if you previously bought. (Remember that an option position can also be cancelled if it expires worthless.) The difference between the price of the option when the trade was initiated and the price when it is offset is the net gain or loss on the trade. Offsetting must be done prior to option expiration, and these differ depending upon the options in question. Expiration calendar for many options can be found in the World Link Futures web site. The holder of a profitable option may, alternatively, elect to exercise the option into a futures, and then offset this new futures position at a profit. He may decide to do this if he believes that prices will continue to move favorably, and so the futures position will further increase in value. (In some cases, for instance, market illiquidity, the option holder may not be able to offset his option position and may have to exercise it into a futures to capture the profits.)
Volume and Open Interest
Just like with futures, options markets have volume and open interest. Volume is a running count of the number of option contracts that have traded during the day and open interest is the number of option contracts outstanding, that is, that have not been closed or offset.
THE RISK OF LOSS IN TRADING COMMODITY CONTRACTS CAN BE SUBSTANTIAL. YOU SHOULD, THEREFORE, CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. FUTURES AND OPTIONS TRADING IS NOT SUITABLE FOR EVERYONE.
FREE EMAIL TRADING COURSE
FREE EDUCATIONAL VIDEOS
FREE STOCK TREND ANALYSIS
MARKET NEWS & COMMENTARY
TRADING BLOG
QUOTES & CHARTS
BASICS OF FUTURES
BASICS OF OPTIONS
HOW THE MARKET WORKS
WHY TRADE FUTURES AND OPTIONS?
THE TRADING PLAN
COMMON TYPES OF ORDERS
PAPER TRADING
FUNDAMENTAL ANALYSIS
TECHNICAL ANALYSIS
TRADING TIPS FOR BEGINNERS
COMMODITIES FOR BEGINNERS
LEARN OPTIONS ON FUTURES
GLOSSARY OF TRADING TERMS
FREQUENTLY ASKED QUESTIONS
SITE MAP