| |
| [ Welcome ] [ About ] [ Products ] [ Affiliate ] [ Privacy ] [ Terms ] [ Testimonials ] [ Guarantee ] [ Contact ] |
This chapter describes commodity options trading basic terms and concepts that are used in this course. The Commodity Futures Glossary (located in Appendix A of my Commodity FUTURES Trading CourseTM) contains virtually every term used in the commodity futures and options trading environment.
An option is a contract that gives you the right, but not the obligation, to either go long or go short the underlying futures contract at a pre-determined entry price on or before a specific date. Each offers the opportunity to take advantage of price moves in the futures markets without actually having a futures position. Options are available for each futures contract delivery month for up to two years into the future.
There are two types of options, call options and put options. Call and put options are separate option contracts. They are not the opposite side of the same contract. For every call buyer there is a call seller, and for every put buyer there is a put seller. The buyer pays a premium to the seller in each transaction.
Call Option
The call option gives the buyer the right, but not the obligation, to go long the underlying commodity futures contract at a pre-specified entry price (i.e., strike price) on or before an expiration date. You would normally buy a call option when you believe that the futures price will increase.
Put Option
A put option gives the buyer the right, but not the obligation, to go short the underlying commodity futures contract at a pre-specified entry price on or before a specific date. A put option is used when you believe the futures price will decrease.
Option Buyer
The buyer or holder of an option can choose to exercise their right and take a futures position, although they nearly always sell it back to the market if it has value.
Option Seller
An option seller is also called the writer. The seller is usually a speculator and is obligated to take the opposite futures position if the buyer exercises their right. In return for the premium, the seller assumes the risk of taking an adverse position.
The option buyer and the seller agree to the following items.
The main advantage of buying options is that you have a predetermined amount of risk, which is the cost of the option and is referred to as the premium. When you buy an option, you pay the premium to the option seller. This is the maximum amount you can lose. When you sell an option (i.e., you are the writer of the option), you receive the premium from the option purchaser. This is the maximum profit you can get with the sale of the option. You get to keep this whether or not the option is exercised. However, while the amount of risk incurred when buying options is limited to the premium (i.e., the cost of the option), the amount of risk incurred when selling options is not limited if the option is exercised by the purchaser.
The following terms are commonly used in the option trading process.
Strike Price
The strike price, also known as the exercise price, is the price at which an option holder – the buyer – may enter the underlying futures contract if they exercise the option. For call options, the strike price is the entry price at which one has the right to go long the underlying commodity futures contract. For put options, this is the entry price at which one has the right to go short the commodity.
Underlying Futures Contract
The corresponding futures contract that may be purchased or sold upon the exercise of the option. For example, an option on the December Silver futures contract is the right to buy or sell one December Silver futures contract.
Premium
The premium is market-determined price (cost) of the option (which does not include commission and fees) that the buyer pays to purchase either a call option or a put option. It is a non-refundable cost which the option seller keeps, and is your maximum amount of risk in the market. Depending on your motive for purchasing the option, the premium represents either the cost of price protection (as a hedger) from adverse price movement, or the cost of opportunity (as a speculator) to potentially profit from a favorable price move with a pre-defined risk amount.
The option premium is quoted just like the price of the underlying futures contract; in cents, points, etc., but in some instances the value of a "tick", or point, is different than the underlying futures contract. Option premiums fluctuate daily due to market conditions. Just like with futures contracts, you profit if you first buy a call option at a specific premium (price), and then sell it back to the market at a higher price. If you monitor changes in an option's premium for at least two weeks, you may be able to buy your option at a lower price.
Professional traders use various statistical analysis to compute what an option's premium should be. However, actual option premiums are determined through competitive bidding at the Exchange. Factors that determine the premium include:
For call options, the closer the strike price is to the underlying futures price, the more expensive the option is. For puts, the closer the strike price is to the futures price, the more expensive the option will be.
Options have two separate components which together define the option's premium. They are time value and intrinsic value.
Time Value
Time value refers to the amount of time remaining before the option expires. The likelihood of an option becoming profitable depends on the amount of time remaining until the option expires. The longer an option has until expiration, the more expensive it will be. This is because the underlying market has more time for price to move, with a greater probability of moving substantially in one direction or another. Time value is a non-linear, decaying component of an option's value, so the loss of the option's time value will increasingly accelerate as time approaches the option's expiration date. This causes the value of the option to rapidly erode with the onset of the expiration date because the likelihood of a large move occurring before expiration decreases. It's a good idea to liquidate unprofitable options three to four weeks before the option's expiration date to avoid the sharp time value loss.
Intrinsic Value
Intrinsic value refers to how much the price of the underlying futures price is, relative to the strike price of the option. The option will have intrinsic value when the price of the futures contract is higher than the strike price of a call, or when the price of the futures contract is lower than the strike price of a put. Options with intrinsic value are referred to as in-the-money options. Generally, when an option is in-the-money, its value is influenced by price changes in the underlying futures contract. However, a volatile market can also cause the value of the option to increase – even though it is not in-the-money. Option with no intrinsic value are out-of-the-money. An option with a strike price equal to the futures price is called at-the-money.
Exercise
This is the action taken by the buyer of an option who wants to "convert" the option into a futures position. Only the buyer has the right to exercise the option. However, the seller has the obligation to take an opposite, and possibly adverse, futures position. Generally, you would not exercise a profitable option. Instead, you would liquidate the option (i.e., sell it back to the market) to benefit from the increased profit. Exercising an option into the underlying futures contract will require you to post margin for the position, and you will also incur an additional cost from the commission to open the futures position.
Expiration Date
All options are assigned an expiration date after which they are no longer valid for trading purposes. This is the last day that the option may be exercised. Frequently, this date will be 2-4 weeks before the underlying futures contract's Last Trading Day (LTD), although some futures items synchronize the option expiration date with the futures contract LTD. The farther out into the future an option's expiration date is, the more expensive the option will be (time = money).
Anytime before the option expiration date, an option purchaser can either exercise the option (i.e., convert it to the underlying futures contract with the strike price of the option being the entry point of the futures contract), liquidate the option (i.e., sell it back to the market), or let it expire worthless. You would only exercise an option if it were in-the-money (that is, the option is profitable). Option speculators rarely exercise their option. Instead, they will liquidate the option to either take profit when it has increased in value, or to prevent further time value loss (especially for expensive options).
If the option is either not exercised or liquidated by the option expiration date, and the option is not in-the-money, it will automatically expire worthless. If an option expires worthless, only the option seller benefits from the trade because they receive the full premium of the option when it was sold. The expired option also lets the option seller get out of their short option position without the need to initiate an offsetting transaction. In contrast, the seller of a futures contract can only get out of their position by offsetting it with another transaction or making delivery on the contract.
Automatic Exercise. At close of the option's expiration date, all in-the-money options are automatically exercised by Board of Trade Clearinghouse. This means if the option you purchased is in-the-money when it expires, it will be converted to the underlying futures contract. If this does happen, make sure you establish a Stop-Loss Order with this futures position! However, it is best not to let this happen by liquidating the option a few weeks prior to the expiration date.
So in summary, you buy either a call or put option to acquire it, and you liquidate your option to relinquish control of it.
Volatility
Volatility is a measure of how fast and how much the futures price changes and is expressed as a percentage – without regard to direction. It is considered one of the most important factors in selecting options for trading. Option prices become expensive when volatility is high (i.e., price movement is quick and there is substantial changes in price magnitude). Conversely, option prices are less expensive when futures prices are quiet, and the market is not moving very much. The higher the volatility of a market, the more expensive an option will be. An option with three months to expiration might command a higher premium in a volatile market than an option with six months to expiration in a stable market.
Of the different ways to measure volatility, the two most important are implied volatility and statistical volatility.
Implied volatility is used to determine the current market price of an option. It uses the Black-Scholes formula to translate option premium into an accurate assessment of what traders "expect" the market to do. In addition, it is a measure of trader sentiment. Option prices are affected most by changes in the underlying futures contract price, and second by changes in trader sentiment.
Statistical volatility (also called historic volatility) is a description of actual price changes during a specific time period in the past. Mathematically, this volatility measure is the annualized standard deviation of daily price during a specific period.
Liquidating Options
When you sell an option you have already bought, you liquidate the option. This is done with an offsetting transaction; that is, you sell the option you previously bought.
Volume and Open Interest
Just like in the futures markets, options markets also have published volume and open interest data. Volume indicates the number of option contracts that have traded during the day and open interest is the number of option contracts which are outstanding (i.e., have not been closed or offset).
Option price tables are set up differently than Futures price tables. Table 2-1 partially shows the Corn option price table appearing in Investor's Business Daily – Friday, December 18, 1998. The size of the contract is stated in the table heading, and is equal to the size of the underlying futures contract. Also shown is the pricing unit for the contract. For Corn, the size is 5,000 bushels and the pricing unit is in cents per bushel. Note: all the values in the option table reflect yesterday's closing data.
Table 2-1
CORN - 5,000 bu, cents per bushel Strike calls puts Price Jan Mar May Jan Mar May 220 1.250 5.875 13.250 0.250 5.125 5.125 230 0.125 2.625 8.000 9.250 11.875 9.875 240 0.125 1.000 4.750 no tr 19.875 16.500 250 0.125 0.500 2.750 no tr 29.500 24.500 260 no op 0.250 1.500 no op 39.375 33.000 Prev day call Vol 2,686 Open int 109,308 Prev day put Vol 2,077 Open int 100,567
The far left-hand column of numbers in the table shows a series of strike prices that may be chosen, ranging from 220 to 260 ($2.20 - $2.60) per bushel. There may be additional strike prices available than those listed. Your broker can tell you more.
There are two groups of three futures contract months listed for both calls and puts – January, March, and May. These columns list the option's premium for each strike price. Options are also available for other futures contract months for up to two years into the future, but only the three nearby months are shown. Your broker can tell you more about both the strike prices and the premiums available for farther out options.
The bottom two lines of the option table shows the previous day's actual volume for calls and puts separately and today's estimated open interest for calls and puts. Remember that the option data listed in the paper represents yesterday's values.
As an example, the premium of a March Corn call option with a 250 strike price is 0.500 (that is, « cent per bushel). For Corn, the premium value to the left of the decimal point represents whole cents, and the value to the right represents part of a cent. To calculate the cost of this option, you would multiply the premium of one-half cent (.005) per bushel by the contract size (5,000 bushels). So each March Corn call option that you purchase at a 250 strike price will cost you $25. This non-refundable cost is the maximum amount of pre-defined risk you will incur.
If, for example, the January Corn futures price was $2.30, the January call option with a strike price of 220 ($2.20) per bushel would have an intrinsic value of ten cents per bushel and would be in-the-money. If the futures price of Corn was $2.20, the January 220 call option would be at-the-money. If the futures price were $2.10 per bushel, the call option would be out-of-the-money by ten cents per bushel and would have an intrinsic value of zero. When an option is out-of-the-money, the premium of the option only represents its time value - that is, the amount the purchaser is willing to pay for the possibility that the option may become profitable before it expires.
Note: An Option Tracking Form is included with this trading course that helps you to monitor and track your active option positions. See Appendix C.
There are several types of orders that can be used when buying options. Commodity options are rapidly bought and sold by open outcry on one of the exchanges. This means the option price can change rapidly and without notice. To give speculators more control over the price paid (or received), special order types have been developed to let you specify conditions which must exist before the purchase of the option can occur. Although the definitions of these orders are commonly used, you are advised to discuss them with your broker and confirm that you both agree to the meanings of these terms.
Day Order
By default (and unless you specify otherwise), all orders you give to your broker are day orders. This means that if you place an order without any of the specifications described below, your order will apply for only that trading day. Each of the following orders may be submitted as a day order, or with other specified conditions. A common overriding condition available to traders is the good until cancelled (also called 'GTC') order. When you specify GTC with your order, you are saying, "I want this order to continue from today onwards, until my order is either filled or I call my broker and cancel the order." Note: if you do place GTC orders, make sure you write it down so you don't forget they exist. This will help you avoid unpleasant surprises when a forgotten order is filled but the market's now going in the opposite direction!
Market Order
This order does not put any restriction on the price you are willing to pay (if you are buying) or accept (if you are selling). It is used to get your order filled quickly. It is important to understand that the last option price quoted is only an indication of the prior market and is not necessarily the price you will receive when your market order is filled. The advantage using a market order is that when markets are trading, your order will generally be filled quickly. The disadvantage is that, in a highly volatile market, your order may be filled at a much higher or lower price than you anticipated.
Limit Order
This order lets you buy at a price lower than the current market price (or to sell at a price higher than the current market price. This order is particularly useful if you are trying to stay within a certain price trading range. Limit orders are generally executed at the limit price, but if your order is filled, you are guaranteed that price – or better. The disadvantage of the limit order is that your price may not be hit and you may miss the market move. By default, the limit order is a day order (i.e., it only applies for that trading day) unless you specify other conditions (i.e., good until cancelled, which means the order stands until it is either filled or cancelled).
Stop Order
This is an order to buy at a price higher than the current market price, or to sell at a price lower than the current market price. Stop orders may be used to buy into an uptrending market or close your position in a downtrending market. The stop order becomes a market order when the stop price is reached (touched). A stop order can be used as a risk management tool to protect open options. If price moves unfavorably (to the stop price), the stop order is executed and the option position is liquidated, preventing any further loss of the option position.
Stop Limit Order
This order is a stop order which becomes a limit order when the market reaches the stop price.
Market-If-Touched Order
This order lets you buy at a price below the current market price or sell at a price higher than the current market price. When the specified price is "touched", this order becomes a market order. This order can only be placed on certain exchanges.
Market-On-Close Order
This order may only be executed in the closing price range at the close of the trading day. This order is not available for all products.
Cancel/Replace Order
This order cancels out a previously entered order and replaces it with a new order.
Long Option
A long option is one that you buy. It can either be a long call or a long put. This is a limited risk option trade.
Short Option
A short option is one that you sell. It can either be a short call or a short put. This is an option trade with risk that is not limited.
Your broker will help you place your order. It's their job to help you – that's why you pay them a commission.
Unless you state otherwise, all orders given to your broker will be Day Orders and will expire at the end of the trading day the order was given. No Open Orders are accepted on New York markets.
The next chapter covers Commodity Options Trading Analysis.
© 1995 - Offer content and all products copyright by Learn-Futures.com. All rights reserved worldwide.
Commodity FUTURES Trading Course 
Commodity OPTIONS Trading Course 
Commodity PYRAMID Trading Course 
Affordable Workshops 
This Newsletter Gives 
Futures & Options