New clients have asked me whether they should trade outright futures contracts, or options on futures, and what the differences are. The answer to this question is not as easy as one might think. It all depends on your timeframe, and your personal level of risk tolerance. In other words, how much money do you want to commit to the trade and what is your level of patience...because an options trade could take many months to become profitable if your price forecast is correct.
First, let's define what an options contract is, and its relationship to futures. A buyer of a call option has the right (but not obligation) to purchase an underlying futures contract at a specified price (the strike price) and within a certain time limit (the expiration date). A buyer of a put option has the right (but not obligation) to sell the underlying futures contract at the strike price on or before the expiration date. A call or put seller is obligated to sell the underlying contract at the agreed-upon price.
An option buyer pays a defined price for the option (the premium) and the seller receives the money. If you buy an option, you have unlimited potential with defined risk, as the most you can lose on the trade is what you paid for the option. On the flip side, the seller has limited profit potential (the premium collected) but unlimited risk. Whether you buy or sell an outright futures contract, your potential losses or gains are virtually unlimited.
Let's look at an example. If you think the price of corn will rally in the future and your level of risk tolerance is high, a futures contract may be the right choice for you. You aren't targeting a specific price forecast by any specific time; you just think corn will go up. Keep in mind, each one-cent move in the price of corn will yield a net gain or loss of $50, as CBOT corn futures are a 5,000-bushel contract. Each market has its own set of specifications, so make sure you know these before you trade so you can determine the right markets for you. As market prices can move quickly in just days, or even minutes, your potential loss or gain can add up quick too. Without the proper risk-management techniques, you could be cashed out of your position if corn plummets today, even if it rallies to new highs next week.
However, say you were to buy a December corn option. You are in essence picking a price target (the strike price) you think the market will reach or exceed, by a certain date (expiration). Your risk is defined to the price you pay for the option, plus your commission costs. And you have until its expiration, in this corn example on Nov. 20, 2007, for the price of corn to rally. If it sells off in the interim, that's alright because you have time on your side with the December option. You aren't out of the game, so to speak, until expiration. Keep in mind, your profit potential will be capped with the options. And, the market must move above your strike price to be profitable with the options position, whereas any rally in futures would net you a gain. For example, say corn futures are trading at $3.48 a bushel, but you think the price will rally. If you decide to buy a futures contract, it's straightforward. You gain on any move above $3.48 (net of commission costs), and you lose on a move below $3.48. If you decide to buy a $4.80 call, the market must rally above that level for you to see a profit on the position, and you'd subtract the premium you paid and your commission costs from that net gain. You aren't going to realize a profit if corn only moves to $4 at expiration, but the futures position would. On the other hand, if the price of corn falls, you let the option expire worthless, and your loss is what you paid for it. On the outright futures position the loss could be much greater.
Options are often used as part of a risk-management strategy in conjunction with futures, for example you could buy a futures contract, and buy a put option if you think there's a risk of a market meltdown. There are many other options strategies that one can utilize, which I will save for another article. If you are interested in talking directly to me to tailor a strategy for your specific needs, please give me a call. And good luck in your trading!
Jim Comiskey is a Senior Market Strategist with Lind-Plus. He can be reached at 888-800-5373 or via email at jcomiskey@lind-waldock.com
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
You can hear market commentary from Lind-Waldock market strategists through our weekly Lind Plus Markets on the Move webinars, as well as online seminars on other topics of interest to traders. These interactive, live webinars are free to attend. Go to www.lind-waldock.com/events to sign up. Lind-Waldock also offers other educational resources to help your learn more about futures trading, including free simulated trading. Visit http://www.lind-waldock.com/
Futures trading involves substantial risk of loss and may not be suitable for all investors. © 2007 MF Global Ltd. All Rights Reserved. Lind-Waldock. Futures Brokers, Commodity Brokers and Online Futures Trading. 141 West Jackson Boulevard, Suite 1400-A, Chicago, IL 60604.
