The Basics of Options Trading

The Basics Of Futures Trading

The Basics of Options Trading Introduction To Options Trading

With the advent of options on futures contracts comes speculation opportunities never before available to the investor. There are seventeen option/ futures strategies now possible! Many of these strategies greatly limit risk while still allowing the opportunity for large profits, as in futures. Some strategies can be profitable even your market predictions are incorrect!

Why Isn’t Everyone Trading Options?

Option profits accrue more slowly than futures and in many cases profits are limited while the potential risk is unlimited. The main reason more people do not trade options is simply lack of knowledge! Options are straightforward to understand. However, they take effort to comprehend. This gives the trader who is willing to do a little work a great advantage. Pacific Rim Asset Management can help you exploit this advantage to the fullest!

Basic Options Explained

An OPTION is an agreement between a buyer and a seller that gives the buyer the right, through exercise, to require the seller to perform certain specified obligations. For example, an option on a piece of property gives the buyer the right, but not the obligation, to purchase the property during a stated period of time at a stipulated price. If the buyer decides to exercise his option to purchase. thc seller is obligated to turn over the property at the agreed upon price. An option which is left unexercised expires worthless after a stated period of time. The price of an option is called its PREMIUM. The premium is the means by which the buyer compensates the seller for his willingness to grant the option. The price at which the option can be exercised is referred to as the STRIKE PRICE.

The last day on which an option can be exercised or offset is known as its EXPIRATION DATE. An option is exercised at the sole discretion of its holder, the buyer, who will tend to exercise only when it is in his interest to do so. For example, the buyer of an option to purchase a house for $90,000 would be foolish to exercise his option if the market value of the house fell to $60,000. On the other hand, it would probably be to his advantage to exercise his right to acquire the house for $90,000 if the house increased in value to $120,000.

Generally, there are two types of options: CALLS and PUTS. A call option gives the buyer the right to purchase the underlying asset at the stated strike price on or before the expiration date. A put option gives the buyer the right to sell the underlying asset at the strike price on or before the expiration date. Because the option buyer will choose to exercise his option only when it profits him to do so, the option serves the option buyer as a device for limiting price risk. The call option holder can make a profit if the underlying asset increases in price, but limits his loss to the cost of the option if the underlying asset loses value. For a put option the opposite is true the holder profits if the price declines but limits his loss if the asset increases in value.

The Option Premium

Since an option’s premium is its cost, it becomes essential for potential traders of options to understand how option premiums are determined, as well as the factors that influence their value. Like futures prices, option premiums are determined at competitive auction. Thus, first and foremost, option premiums are a function of supply and demand for option contracts at any particular time. Typically, the demand for calls, options to buy futures, is strongest when prices are rising. Consequently, the demand for puts, options to sell futures, is strongest when prices are falling. The exact price that buyers and sellers are willing to accept at a particular time has two primary components: the intrinsic value of the option and the time value of the option.

Time Value

An option’s time value is the amount by which the option premium (its actual cost) is above the option’s intrinsic value,. Time value reflects any additional amount that buyers are willing to pay in the hope that changes in the underlying futures price prior to expiration will increase the option’s intrinsic value. The premium of an out-of-the money option is thus entirely a reflection of its time value. For example. assume an $5 December Silver call option* has a premium of $1,125 ($.225 an ounce ) with December Silver trading at $4.60 an ounce. The option has no intrinsic value and $1125 of time value.

The time value of an option declines as time passes since there is less and less time remaining for the option to develop intrinsic value. In addition, an option that is deep out-of-the-money (when a substantial difference exists between the strike and futures prices) will have less time value than an option that is only slightly out-of-the-money, since it is less likely to ever become profitable to exercise. The Current Premium At any time prior to its expiration, an option’s value will be influenced by: the price of the underlying futures contract, the option’s strike price, the time remaining until expiration, the volatility of the underlying futures contract, and the current risk-free interest rate.

Intrinsic Value

An option’s INTRINSIC VALUE is the amount by which the futures price is above a call option’s strike price. or below a put option’s strike price. This is equivalent to the option’s value at exercise. An option which has intrinsic value is said to be in-the-money. An option without intrinsic value is said to be out of-the-money. If the futures price is the same as the strike price of an option. the option is at-the-money and has no intrinsic value; For example, if the December Silver futures contract is trading at $5 an ounce, a December call option with a strike price of $4 would have $1 of intrinsic value. A corresponding 4 put option would have no intrinsic value, since the futures price is greater than the option’s strike price. If December Silver was trading at $4, however, a $5 put option would have $1 of intrinsic value. Options usually trade for at least their intrinsic value. Any time an option premium is less than the option’s intrinsic value, an arbitrageur will buy the option, exercise it, and then offset the resulting futures position at a profit, assuming he can cover transaction costs.

Exchange Traded Futures

Options Like futures contracts, all options are bought and sold at competitive auction on the floor of the Exchange. The “open outcry” trading system provides fair and orderly price discovery for option premiums, and permits close supervision by the Exchange’s Compliance and Surveillance Departments, which monitor trading. At the end of each trading day, all option transactions are accepted and cleared by the Clearing Association. assuring performance on all contract obligations, and freeing buyers and sellers of any further direct Obligations to each other. Many investors find the benefits of purchasing options highly attractive. Chief among these benefits are leverage, limited price risk, and staying power. The buyer of an option can realize enormous returns ten times or more the investment for some trades through his s ability to control a futures contract with a small premium outlay. Meanwhile, the buyer’s downside risk is strictly limited to the option’s cost (i.e., the premium plus any transaction costs).

To illustrate, an investor who buys an at-the-money silver call option for a premium of 25.00 cents per ounce with silver at $5, might make almost $2.50 per ounce, or $12,500, if silver moves to $7.50 an ounce before the option expires. On the other hand, if silver drops below $5 and the option expires worthless, the investor can lose no more than his initial investment of 25.00 cents per ounce, or $1 .250***. Because of limited risk. purchasing options offers an investor what is known as staying power, or the ability to hold onto a losing position in the face of a market reversal without calling for additional funds in the form of margin. Finally, futures options are traded on the Exchange where there is a readily available re-sale market, so an investor can always trade out of an option position if he chooses to do so prior to expiration.

This last point is particularly important. An investor who has a paper profit in options is not required to exercise his options in order to realize his profit. Instead, he simply liquidates his option in the options market. Thus. a buyer of options need not get involved in the futures market unless he explicit15 chooses to do so.

Examples of Options Trading I ) When a December gold futures contract is trading at 500: A 525 gold call purchased in October gives the speculator the right, but not the obligation, to buy the December futures contract at 525 any time between the date of purchase and the expiration date of the option. **Frequently. the option whose strike price is nearest to the underlying futures price is referred to as ”at-the-money.” ***All examples in this section exclude transaction costs. which must be taken into account. Premiums used in the examples are for illustrative purposes only. This is an out-of-the-money call since the gold futures contract is trading below the 525 strike price.

Thus, the speculator when he buys this option will only pay for time value. The cost of the option will vary with time, volatility of gold futures, and current market expectations. The exact price paid will be determined in an open outcry trading pit with demand for the option setting the price. The only value this out-of-the money option has is what people think it might be worth sometime in the future.

The price of the option will constantly change with time and price of the futures.

2) When a December gold futures contract is trading at 500: A 475 gold call purchased in October gives the speculator the right, but not the obligation, to buy the December gold futures contract at 475 any time between the date of purchase and the expiration date of the option.

This is an in-the-money call since thc gold futures contract is trading above the 475 strike price. In this case, when the speculator pays the option premium (the cost of thc option) it will be determined by: a) The time until the option expires, and b) The amount that the option is in-the-money (since you have the right to buy gold at 475 and it is already at 500).

3) The put option works in reverse of the call option so that the buyer of puts is looking for the futures market to move lower!

4) Option traders can also sell (write or grant) options. If a speculator feels that gold will not move very far in one direction, he can sell an option (either a put or a call) to the options buyer/ speculator and collect the premium. But he is then obligated to perform should the holder of the option exercise his right. Therefore, the option seller has limited income potential, the premium collected, and unlimited risk! (The futures contract could go a long way in-the-money which could result in substantial losses for the option writer.)

There are more than a dozen option strategies using options and futures together to invest. For more information, contact a Pacific Rim Asset Management broker.