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A Guide to Understanding Opportunities and Risks in Futures Trading

from The National Futures Association

Options on Futures Contracts

What are known as put and call options are traded on most active futures contracts. The principal attraction of buying options is that they make it possible to speculate on increasing or decreasing futures prices with a known and limited risk. The most that the buyer of an option can lose is the cost of purchasing the option (known as the option "premium") plus transaction costs.

Options can be most easily understood when call options and put options are considered separately, because they are totally separate and distinct. Buying or selling a call in no way involves a put, and buying or selling a put in no way involves a call.

Buying Call Options

The buyer of a call option acquires the right, but not the obligation, to purchase (go long) a particular futures contract at a specified price at any time during the life of the option. Each option specifies the futures contract which may be purchased (known as the "underlying" futures contract) and the price at which it can be purchased (known as the "exercise" or "strike" price).

A March Treasury bond 92 call option would convey the right to buy one March U.S. Treasury bond futures contract at a price of $92,000 at any time during the life of the option.

One reason for buying call options is to profit from an anticipated increase in the underlying futures price. A call option buyer will realize a net profit if, upon exercise, the underlying futures price is above the option exercise price by more than the premium paid for the option. Or a profit can be realized if, prior to expiration, the option rights can be sold for more than they cost.

Example: You expect lower interest rates to result in higher bond prices (interest rates and bond prices move inversely). To profit if you are right, you buy a June T-bond 90 call. Assume the premium you pay is $2,000.

If, at the expiration of the option (in May) the June T-bond futures price is 93, you can realize a gain of three (that’s $3,000) by exercising or selling the option that was purchased at 90. Since you paid $2,000 for the option, your net profit is $1,000 less transaction costs.

As mentioned, the most that an option buyer can lose is the option premium plus transaction costs. Thus, in the preceding example, the most you could have lost — no matter how wrong you might have been about the direction and timing of interest rates and bond prices — would have been the $2,000 premium you paid for the option plus transaction costs. In contrast, if you had an outright long position in the underlying futures contract your potential loss would be unlimited.

It should be pointed out, however, that while an option buyer has a limited risk (the loss of the option premium), his profit potential is reduced by the amount of the premium. In the example, the option buyer realized a net profit of $1,000. For someone with an outright long position in the June T-bond futures contract, an increase in the futures price from 90 to 93 would have yielded a net profit of $3,000 less transaction costs.

Although an option buyer cannot lose more than the premium paid for the option, he can lose the entire amount of the premium. This will be the case if an option held until expiration is not worthwhile to exercise.

Buying Put Options

Whereas a call option conveys the right to purchase (go long) a particular futures contract at a specified price, a put option conveys the right to sell (go short) a particular futures contract at a specified price. Put options can be purchased to profit from an anticipated price decrease. As in the case of call options, the most that a put option buyer can lose, if he is wrong about the direction or timing of the price change, is the option premium plus transaction costs.

Example: Expecting a decline in the price of gold, you pay a premium of $1,000 to purchase an April 300 gold put option. The option gives you the right to sell a 100 ounce gold futures contract for $300 an ounce.

Assume that, at expiration, the April futures price has — as you expected — declined to $280 an ounce. The option giving you the right to sell at $300 can thus be sold or exercised at a gain of $20 an ounce. On 100 ounces, that’s $2,000. After subtracting $1,000 paid for the option, your net profit comes to $1,000.

Had you been wrong about the direction or timing of a change in the gold futures price, the most you could have lost would have been the $1,000 premium paid for the option plus transaction costs. However, you could have lost the entire premium.

How Option Premiums are Determined

Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers. Three major variables influence the premium for a given option:

  • The option’s exercise price, or more specifically, the relationship between the exercise price and the current price of the underlying futures contract. All else being equal, an option that is already worthwhile to exercise (known as an "in-the-money" option) commands a higher premium than an option that is not yet worthwhile to exercise (an "out-of-the-money" option). For example, if a gold contract is currently selling at $290 an ounce, a put option conveying the right to sell gold at $310 an ounce is more valuable than a put option that conveys the right to sell gold at only $280 an ounce.
  • The length of time remaining until expiration. All else being equal, an option with a long period of time remaining until expiration commands a higher premium than an option with a short period of time remaining until expiration because it has more time in which to become profitable. Said another way, an option is an eroding asset; its time value declines as it approaches expiration.
  • The volatility of the underlying futures contract. All else being equal, the greater the volatility the higher the option premium. In a volatile market, the option stands a greater chance of becoming profitable.
Selling Options

At this point, you might well ask, who sells the options that option buyers purchase? The answer is that options are sold by other market participants known as option writers, or grantors. Their sole reason for writing options is to earn the premium paid by the option buyer. If the option expires without being exercised (which is what the option writer hopes will happen), the writer retains the full amount of the premium.

It should be emphasized and clearly recognized, however, that unlike an option buyer who has a limited risk (the loss of the option premium), the writer of an option has unlimited risk. His loss, except to the extent offset by the premium received when the option was written, will be whatever amount the option is "in-the-money" at the time of expiration. Simply said, any profit realized by an option buyer represents a loss for the option seller. And, it’s worth saying again, there is no limit on how large this loss can be!

The foregoing is, at most, a brief and incomplete discussion of a complex topic. Options trading has its own vocabulary and its own arithmetic. If you wish to consider trading in options on futures contracts, you should discuss the possibility with your broker and read and thoroughly understand the risk disclosure statement which he is required to provide. In addition, have your broker provide you with educational and other literature prepared by the exchanges on which options are traded. Or contact the exchange directly. A number of excellent publications are available, including Options on Futures Contracts: An Introduction, which can be obtained by calling NFA’s Information Center toll-free at (800) 621-3570 or by visiting NFA’s web site at www.nfa.futures.org.

Next chapter: In Closing


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