Buying a Put Option
A person would buy a put option if they expected the price of the underlying futures contract to move lower. A put option gives the buyer the right to sell the underlying futures contract at an agreed-upon price—called the strike price—any time before the contract expires. Because buying a put gives the right to sell the contract, the buyer is taking a short position in the futures contract. The person selling the put option would be taking a long position.
Options are considered to be derivatives of futures because they derive their value from the value of the futures contract they're associated with. Calls are the other type of option. They give the buyer the right to purchase the underlying futures contract before the expiration date.
Futures contracts—and, consequently, options—can be based on a variety of assets or financial markers, including interest rates, stock indexes, currencies, and energy, agricultural, and metal commodities.
A put option is said to be in the money when the market price of its underlying futures contract is lower than the strike price because the put owner has the right to sell the contract for more than it's currently worth. A put option is out of the money when the market price of its underlying futures contract is higher than the strike price because the put owner could only sell the contract for less than it's currently worth.
Finding the Right Put Option to Buy
Things to consider when determining which put option to buy include:
- Duration of time you plan on being in the trade.
- Amount you can allocate toward buying the option.
- Length of move you expect from the market.
Most futures exchanges have a wide range of options in different expiration months and different strike prices that enable you pick an option that meets your objectives.
Duration of Time
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 six to nine months remaining if you plan on being in the trade for only a couple weeks, since the option will be more expensive.
One thing to be aware of is that the time premium of options—their value based on how much time they have left before expiration—decays more rapidly in the last 30 days. Therefore, you could be right on a trade, but the option could lose too much time value and you would end up with a loss regardless. Therefore, you should always buy an option with 30 more days until expiration than you expect to be in the trade.
Amount You Can Afford
Depending on your account size and risk tolerance, some options may be too expensive for you to buy. In-the-money put options will be more expensive than out-of-the-money options. And the more time that remains before the expiration date, the more the options will cost.
Unlike with 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 futures 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 Move
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
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 in value as quickly as futures contracts unless they are deep in the money. That lower volatility 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 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—they're theoretically 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.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.