The Basics of Futures Options
Futures options can be a low-risk way to approach the futures markets. Many new traders start by trading futures options instead of straight futures contracts. There is less risk and volatility when buying options compared with futures contracts. Many professional traders only trade options. Before you can trade futures options, it is important to understand the basics.
An option is the right, not the obligation, to buy or sell a futures contract at a designated strike price for a particular time. Buying options allows a trader to speculate on changes in the price of a futures contract. This is accomplished by purchasing call or put options.
The purchase of a call option is a long position, a bet that the underlying futures price will move higher. For example, if one expects corn futures to move higher, they might buy a corn call option. The purchase of a put option is a short position, a bet that the underlying futures price will move lower. For example, if one expects soybean futures to move lower, they might buy a soybean put option.
Premium: The price the buyer pays and seller receives for an option is the premium. Options are price insurance. The lower the odds of an option moving to the strike price, the less expensive on an absolute basis and the higher the odds of an option moving to the strike price, the more expensive these derivative instruments become.
Contract Months (Time): All options have an expiration date; they only are valid for a particular time. Options are wasting assets; they do not last forever. For example, a December corn call expires in late November. As assets with a limited time horizon, attention must be accorded to option positions. The longer the duration of an option, the more expensive it will be. The term portion of an option's premium is its time value.
Strike Price: This is the price at which you could buy or sell the underlying futures contract. The strike price is the insurance price. Think of it this way: The difference between a current market price and the strike price is similar to the deductible in other forms of insurance. As an example, a December $3.50 corn call allows you to buy a December futures contract at $3.50 anytime before the option expires. Most traders do not convert options to futures positions; they close the option position before expiration.
Buying an Option
If one expects the price of gold futures to move higher over the next 3 to 6 months, they would likely purchase a call option.
Purchase, 1 December $1,400 gold call at $15:
- 1: number of option contracts bought (represents 1 gold futures contract of 100 ounces)
- December: Month of option contract
- $1,400: strike price
- Gold: underlying futures contract
- Call: type of option
- $15: premium ($1,500 is the price to buy this option or, 100 ounces of gold x $15 = $1,500)
Buying an option is the equivalent of buying insurance that the price of an asset will appreciate. Buying a put option is the equivalent of buying insurance that the price of an asset will depreciate. Buyers of options are purchasers of insurance.
When you buy an option, the risk is limited to the premium that you pay. Selling an option is the equivalent of acting as the insurance company. When you sell an option, all you can earn is the premium that you initially receive. The potential for losses is unlimited. The best hedge for an option is another option on the same asset as options act similarly over time.
The Importance of Volatility
The chief determinate of option premiums is “implied volatility,” or the market’s perception of the future variance of the underlying asset. Historical volatility, on the other hand, is the actual historical variance of the underlying asset in the past.