Buying a Put Option
Buying a put option entitles the buyer of the option the right to sell the underlying futures contract at the strike price any time before the contract expires. This rarely happens and there is not much benefit to doing this, so don’t get caught up in the formal definition of buying a put option.
Most traders buy put options because they believe a commodity market is going to move lower and they want to profit from that move. You can also exit the option before it expires – during market hours, of course.
All options have a limited life. They are defined by a specific expiration date by the futures exchange where it trades. You can visit each futures exchange’s website for specific expiration dates of each commodities market.
Finding the Proper Put Options to Buy
You must first decide on your objective and then find the best option to buy. Things to consider when buying put options include:
- Duration of time you plan on being in the trade.
- Amount you can allocate to buying a put option.
- Length of a move you expect from the market.
Most commodities and futures have a wide range of options in different expiration months and different strike prices that allow you pick an option that meets your objectives.
Duration of Time You Plan on Being in the Trade
This will help you determine how much time you need on a put option. If you are expecting a commodity to complete its move lower within two weeks, you will want to buy a commodity with at least two weeks of time remaining on it. Typically, you don’t want to buy an option with 6-9 months remaining if you only plan on being in the trade for a couple weeks, since the options will be more expensive and you will lose some leverage.
One thing to be aware of is that the time premium of options decays more rapidly in the last 30 days. Therefore, you could be right on a trade, but the option loses too much time value and you end up with a loss. I suggest that you always buy an option with 30 more days than you expect to be in the trade.
Amount You Can Allocate to Buying a Put Option
Depending on your account size and risk tolerances, some options may be too expensive for you to buy or they might not be the right options altogether. In the money put options will be more expensive than out of the money options. Also, the more time remaining on the put options there is, the more they will cost.
Unlike futures contracts, there is no margin when you buy futures options. You have to pay the whole option premium upfront. Therefore, options on volatile markets like crude oil can cost several thousand dollars. That may not be suitable for all options traders. And you don’t want to make the mistake of buying deep out of the money options just because they are in your price range. Most deep out of the money options will expire worthless and they are considered long shots.
Length of a Move You Expect From the Market
To maximize your leverage and control your risk, you should have an idea of what type of move you expect from the commodity or futures market.
The more conservative approach is usually to buy in the money options. A more aggressive approach is to buy multiple contracts of out of the money options. Your returns will increase with multiple contracts of out of the money options if the market makes a large move lower. It is also riskier as you have a greater chance of losing the entire option premium if the market doesn’t move.
Put Options vs. a Futures Contract
- Limited Risk
- Less Volatility
Your losses on buying a put option are limited to the premium you paid for the option plus commissions and any fees. With a futures contract, you have virtually unlimited loss potential.
Put options also do not move as quickly as futures contracts unless they are deep in the money. This allows a commodity trader to ride out many of the ups and downs in the markets that might force a trader to close a futures contract in order to limit risk.
One of the major drawbacks to buying options is the fact that options lose time value every day. Options are a wasting asset – theoretically, they are worth less each day that passes. You not only have to be correct on the direction of the market but also on the timing of the move.
Break Even Point:
Strike Price + Option Premium Paid
This formula is used at option expiration considering there is no time value left on the put options. You can obviously sell the options anytime before expiration, where there will be time premium unless the options are deep in the money or far out of the money.
A put option can also serve as a limited-risk stop-loss instrument for a long position. In volatile markets, it is advisable for traders and investors to use stops against risk positions. A stop is a function of risk-reward and as the most successful market participants know, you should never risk more than you are looking to make on any investment.
The problem with stops is that sometimes the market can trade to a level that triggers a stop and then reverse. For those with long positions, a long put option serves as stop loss protection, but it can give you more time than a stop that closes the position when it trades to the risk level. That is because if the option has time left if the market becomes volatile; the put option serves two purposes.
First, the put option will act as price insurance, protecting the long position from additional losses below the strike price. Second, and perhaps more importantly, the put option allows the opportunity to stay long even if the price drops below the insured level or the strike price. Markets often fall only to turn around and rise dramatically after the price triggers stop orders. As long as the option still has time until expiration, the put option will keep a market participant in a long position and allow them to survive a volatile period that eventually returns to an uptrend. A long position together with a long put is essentially the same as a long call position, which has limited risk.
Put options are instruments that can be employed to position directly in a market to bet that the price will decline or to protect an existing long position from an adverse price move.