What are Options?

Source: This publication is the property of the National Futures Association

OPTIONS TRAINING  

26 Plain Language Answers to Questions about Buying Options

Mainly because they have a known and limited risk, options on futures contracts have become an attractive investment for many individuals seeking to profit from significant price movements, either upward or downward, in today's increasingly volatile and often uncertain investment environment.

Almost 200 million options, encompassing a wide variety of basic commodities and financial products, are traded annually on the nation's regulated exchanges.

TABLE OF CONTENTS

1.     What is my maximum risk if I buy an option?

2.     Aren't options a risky investment?

3.     Why are options on futures such an increasingly popular investment?

4.     What exactly is an option?

5.     Other than "call" and "put," what terms do I need to be familiar with?

6.     How are profits realized in option investing?

7.     As an example, if I buy an option to purchase 100 ounces of gold at a strike price of $300 an ounce and the price goes to $330 an ounce, what's my profit?

8.     How large is my profit potential when I buy an option?

9.     At the present time, what options can be purchased?

10.  How long is the life of an option?

11.  When I buy an option, how is the premium cost arrived at?

12.  What major factors influence the premium cost of a particular option?

13.  Exactly how much does the price of the commodity have to change in order to realize a profit on the option?

14.  It's often said a major advantage of options is "leverage." What does this mean?

15.  But can't leverage work both ways, against as well as for you?

16.  Once I've bought an option, will there be a continuing market for that option?

17.  Suppose an option I've bought very quickly becomes profitable. Do I have to wait until the expiration date to sell it?

18.  Can I sell an option even if it isn't currently worthwhile to exercise?

19.  Can I follow an option's current market value on a regular basis?

20.  How much should I know about the underlying commodity in order to consider investing in options?

21.  When I purchase an option, who is the party on the other side of the transaction?

22.  Who assures payment on exchange-traded option contracts?

23.  What brokerage commissions are involved in buying options?

24.  What place do options have in an overall investment program?

25.  How do options compare with other investments that involve similar risk and reward?

26.  Investment experts mention the "positioning" advantage of options. What exactly do they mean?

1. What is my maximum risk if I buy an option?

The nature and amount of downside risk is a good first question to ask about any investment you may be considering. In the case of options, the maximum risk is that you could potentially lose the money, known as the premium, which you invested to purchase that particular option. And, of course, you can lose the brokerage and transaction costs involved in making the investment. There can be no assurance any given option will become worthwhile to sell or exercise. Profitability depends on whether the price movement you anticipate occurs during the life of the option. top

2. Aren't options a risky investment?

Options are an inappropriate investment for some people. This is why your broker will ask you questions that may seem somewhat personal about your financial situation and objectives and will require that you acknowledge reading and understanding a Risk Disclosure document prepared by the Commodity Futures Trading Commission. Money needed for family living, insurance protection and basic savings programs obviously should never be committed to any form of investment that involves significant risk, regardless of the opportunity for profit. top

3. Why have options on futures become such an increasingly popular investment?

Options make it possible to realize a potentially substantial profit, often in a short period of time, with a relatively small investment and with a known and limited risk. Under no circumstances can the loss exceed the cost of purchasing the option.

Other advantages include:

         The leverage inherent in options.

         The liquidity provided by established competitive option markets.

         Investment diversification.

         The flexibility to respond rapidly to market opportunities.

         The ability to follow the value of your investment on a day-to-day basis.

         The staying power to weather temporary setbacks without incurring additional risk or costs.

         Freedom from the margin calls that many other investments are subject to.

         Strict federal industry regulation.

         The opportunity to realize profits during periods of falling as well as rising prices.

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4. What exactly is an option?

There is regulated exchange trading in two types of options on futures contracts, known as call options and put options. Which one to consider investing in will depend entirely on your price expectations, that is, on whether you expect the price of a particular commodity to go up or you expect it to go down.

         CALL OPTION Purchasing a call gives you a specific locked-in price at which you have the right, but not the obligation, to buy a futures contract on a commodity that you expect to increase in value. For example, if you predict that the price of gold will go up, you'd buy a gold call option.

         PUT OPTION Purchasing a put gives you a specific locked-in price at which you have the right, but not the obligation, to sell a futures contract on a commodity that you expect to decrease in value. Thus, if you look for the price of gold to go down, you'd buy a gold put option.

One easy way to remember which is which is to think of the terms "call up" and "put down." A call is a way to profit if prices go up. A put is a way to profit if prices go down. If and when the market price of the commodity moves in the direction you anticipated, this will be reflected on a daily basis in the value of your option. top

5. Other than "call" and "put," what terms do I need to be familiar with?

Just a couple. You should know what's meant by an option's "premium" and by its "strike price."

Premium. Used in connection with options, premium has the same meaning as when used in connection with insurance. It's the price that you pay to buy a given option. (See question 11 for an explanation of how option premiums are determined.) Strike Price. This is the specific price at which the option gives you the right to buy a particular commodity in the case of a call or to sell the commodity in the case of a put. The strike price is stated in the option.

Example: If a call option gives you the right to buy 100 ounces of gold at a price of $500 an ounce, $500 is the strike price. At any given time, there is likely to be trading in options with a number of different strike prices.

When you buy a call, you hope the market price of the commodity will move above the option's strike price by an amount greater than the cost of the option, thereby causing the option to become profitable. When you buy a put, you hope that the market price of the commodity will decline below the option's strike price by an amount greater than the cost of the option. top

6. How are profits realized in option investing?

Generally by instructing your broker to sell your appreciated option rights to someone who may have an interest in exercising them. The sale will be accomplished on the trading floor of the exchange (the same exchange where the option was bought) and your net profit will be the difference between the price that you originally paid for the option and the higher price that you are able to sell it for, less brokerage and transaction expenses. The mechanics are no more complicated than, for example, selling shares of common stock that have appreciated. An alternative to selling a profitable option is to exercise the option rights. Doing this, however, would result in your actually acquiring a position in the futures market - which could require an additional investment on your part and involve significantly greater risks. Most investors therefore prefer to realize their profits by simply selling the option at its increased value. top

7. As an example, if I buy an option to purchase 100 ounces of gold at a strike price of $500 an ounce and the price of gold goes to $540 an ounce, what's my profit?

If gold climbs to $540 an ounce at expiration, your call option with a $500 strike price will have a value of $4,000 - the $40 an ounce price increase times 100 ounces. The profit will depend on what you paid for the option to start with. If your total costs (premium plus brokerage and transaction costs) were, say, $800, then your profit will be $3,200 - the difference between the $800 you paid for the option and the $4,000 you can now sell it for. As mentioned, the same broker who handled the purchase can handle the sale. (Question 17 has more information about selling a profitable option.)

Illustration of profit or loss on a 100-ounce gold call option if the option strike price is $500 an ounce and the cost of purchasing the option was $800 ($8 an ounce):

If gold futures price
at expiration is

Value of option at expiration

Cost of option

Your profit

$500 or less

0

$800

$800 loss

$505

$500

$800

$300 loss

$520

$2,000

$800

$1,200 profit

$540

$4,000

$800

$3,200 profit

$560

$6,000

$800

$5,200 profit

$580

$8,000

$800

$7,200 profit

$600

$10,000

$800

$9,200 profit

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8. How large is my profit potential when I buy an option?

There is no upper limit on the opportunity for profit. The greater the price movement, provided it's in the direction you anticipated and provided it occurs during the life of the option, the larger the profit. As previously indicated, it is the combination of limited risk and unlimited opportunity that is a principal attraction of options as an investment vehicle. top

9. At the present time, what options can be purchased?

The list of exchange-traded options has grown rapidly and now includes a broad range of agricultural commodities, precious metals, energy products, financial instruments, and foreign currencies. The following is a partial listing by category:

COMMODITY GROUP

OPTIONS TRADED

Agricultural Commodities

These reflect basic supply-demand developments and may provide a
leading indicator of renewed inflation.

Corn
Wheat
Soybeans
Oats
Pork -
Bellies
Cattle

Coffee
Cocoa
Lumber
Sugar
Cotton
Hogs

Metals

Prices often rise sharply during periods of inflation and decline during recessions.
They can be volatile in either direction in times of economic uncertainty.

Gold
Copper
Silver

Energy Products

As history has shown, prices can move rapidly and substantially in response
to political and economic events.

Crude Oil
Heating Oil
Unleaded Gas
Natural Gas

Interest Rates

Even relatively small changes in interest rates can result in major changes
of fixed income investments.

U.S. Treasury Bonds
U.S. Treasury Notes
U.S. Treasury Bills
Municipal Bonds
Eurodollars

Common Stock Indexes

Indexes reflect increases and decreases in the market value of common stocks.

S&P 500 Index
Dow Jones Index
Nasdaq Index

Currencies

Trade balances and government policies can influence the value of
foreign currencies in relation to the dollar.

British Pound
Swiss Franc
Japanese Yen Canadian Dollar
Euro Currency
U.S. Dollar Index

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10. How long is the life of an option?

There is normally trading in options that have different lengths of time remaining until expiration - from less than a month to twelve or more months. The choice is yours. This flexibility makes it possible to select whichever option best coincides with when you expect a given price movement to occur.

Example: Buying an option that expires in September allows two more months for the expected price change to take place than buying an option that expires in July.

Purchasing a longer option increases the premium cost of the option somewhat (see question 12) but, as with most things in life, it's usually best to allow at least a little extra time for an expected event to occur! Don't hesitate to seek your broker's assistance in deciding how long an option would be advisable to consider purchasing. top

11. How is the premium cost arrived at?

As mentioned, the premium refers to the price you pay to buy an option. It also refers to the price you receive if and when you subsequently sell the option. Like prices on the trading floor of a stock exchange or futures exchange, option premiums are arrived at through open competition between brokers representing buyers and sellers. Option markets are thus quite literally supply and demand marketplaces. Trading is subject to the rules of the exchange and is closely regulated by the Commodity Futures Trading Commission (CFTC), a federal agency. Firms that deal in options are also subject to CFTC regulation and to regulation by the National Futures Association (NFA), the industry's congressionally authorized self-regulatory organization. top

12. What major factors influence the premium cost of a particular option?

There are three factors and two of them have already been mentioned: the amount of time remaining until expiration and the option's strike price. A third variable is the volatility of the markets.

Time to expiration All else being equal, an option with more time until expiration commands a larger premium than an option with less time until expiration. The longer option provides more time for your price expectations to be realized.

Strike price In the case of call options, it stands to reason that the most valuable options are those that convey the right to buy at a low price. Thus, all else being equal, a call option with a low strike price costs more to purchase than a call option with a high strike price. It's just the opposite for put options. The most valuable puts are those that have a high strike price.

Volatility Again, all else being equal, option premiums are usually higher when the markets are volatile. Volatile markets are considered more likely to produce the price movements that can make options profitable to own. top

13. Exactly how much does the price of the commodity have to change in order for me to realize a profit on the option?

Fortunately, this important calculation is also a simple calculation - a matter of addition or subtraction, depending on whether you are buying a call option or a put option. The only two factors involved are the cost of the option and the option's strike price.

Calls To realize a profit on an expiring call, the market price of the commodity must move above the option strike price by an amount greater than your costs (costs include the premium invested to buy the option, brokerage commission, and any other transaction costs).

Example: In anticipation of rising prices, you invest $800 (the equivalent of $8 an ounce) to buy a 100-ounce gold call option with a strike price of $500 an ounce. For the option to become profitable at expiration, the price of gold must climb above $508. For each $1 an ounce it increases above that amount, your profit is $100.

Puts To realize a profit on a put, the market price of the commodity must decline below the option strike price by an amount greater than your costs.

Example: In anticipation of declining prices, you invest $800 (the equivalent of $8 an ounce) to buy a 100-ounce gold put option with a strike price of $500 an ounce. For the option to become profitable at expiration, the price of gold must decline below $492. For each $1 an ounce it declines below that amount, your profit is $100. top

14. It's often said a major advantage of options is "leverage. "What does this mean?

Greater leverage, which options provide, means that even a small favorable movement in the underlying commodity price can yield a high percentage rate of return on your investment.

Example: You've invested $800 to buy a three-month gold call option with a strike price of $500 and the price of gold has climbed to $540. The option that cost only $800 can now be sold for $4,000. The net profit of $3,200 represents a quadrupling of your investment in three months. Stated another way, it took only an 8% increase in the price of gold (from $500 to $540) to give you a 300% return on your $800 investment. That's leverage. top

15. But can't leverage work both ways, against as well as for you?

That's true. The potential for a high percentage return on your investment should be weighed against the risk that, if the option does not become worthwhile to sell or exercise by expiration, you would lose your entire investment in that particular option. Even so, buying an option can involve much less dollar risk than the alternative of owning the actual commodity.

Example: At the same time you spent $800 to buy a 100-ounce gold call option with a $500 strike price, your wealthy neighbor plunked down $50,000 to purchase 100 ounces of gold bullion. If the price of gold drops to, say, $450 at expiration, your option will be worthless and you'll have lost $800 - 100% of your investment. Your neighbor, if he decides to sell the bullion, will incur only a 10% loss, but he will be out $5,000 - compared with your $800 loss. top

16. Once I've bought an option, will there be a continuing market for that option?

There's generally an active market in outstanding options right up to the day of expiration. However, if an option is no longer deemed to have much, or any, chance of ever becoming worthwhile to exercise, there may not currently be any market for it. top

17. Suppose an option I've bought very quickly becomes profitable. Do I have to wait until the expiration date to sell it?

Absolutely not. When to sell such an option, and take your profits, is entirely up to you. On the one hand, continuing to hold the option until nearer its expiration date could result in your realizing an even larger profit. But, on the other hand, an unexpected adverse price movement could result in a reduction in the value of the option. Deciding when to sell a profitable option is thus a "bird-in-the-hand" type of decision.

A somewhat technical point to bear in mind in making the decision is that in addition to whatever a given option would currently be worth to exercise, options that haven't yet expired may also have what's called "time value."

Example: With gold at $540 an ounce, a 100-ounce gold call option with a strike price of $500 will be worth $4,000 to exercise. But if it still has time remaining until expiration, you may be able to sell it for more than $4,000 - the difference being its time value.

Specifically, time value is whatever amount other investors in the marketplace are willing to pay you, over and above what the option is currently worth to exercise, as additional compensation for giving up your option rights prior to expiration. This will be reflected in the option premium. Your broker can explain in greater detail. top

18. Can I sell an option even if it isn't currently worthwhile to exercise?

The answer is yes if the option still has time remaining until expiration and if there is still active trading in that particular option. Whether the sale results in a profit or a loss will depend, as with any option, on whether you sell it for more or for less than you paid for it.

A favorable change in the price outlook or an increase in market volatility can make an option suddenly more attractive to other investors. If this results in an increase in its premium value, you may be able to sell the option at a profit even though it isn't yet worthwhile to exercise.

In other situations, if prices so far haven't moved the way you thought they would, and if you no longer want to own the option, selling it prior to expiration can provide a way to recover some part of your initial investment. Such a decision should not be made hastily, however. The fact that you have until expiration for your original price expectations to be realized can give you greater "staying power" than other investors may enjoy.

It is this "staying power," the ability to weather what may prove to be only a temporary price setback, that is one of the principal advantages of investing in options. No matter how large the adverse price movement, your maximum loss is still limited to the cost of the option. top

19. Can I follow an option's current market value on a regular basis?

Yes, very easily. Options on futures contracts are traded on regulated exchanges that have continuous electronic quotation systems. Business periodicals such as the Wall Street Journal and many major newspapers report actively traded futures prices and option premiums daily. Or you can phone your broker who has computer access to current option premiums. The opportunity to know at all times what your investment is worth is another attractive feature of exchange-traded options. top

20. How much should I know about the underlying commodity in order to consider investing in options?

The reason for buying an option is that you have an opinion about the probable price movement of a particular commodity. The opinion can be derived from your own knowledge or, as is the case with most investors, by dealing with a brokerage firm in whose research and analytical abilities you have confidence. top

21. When I purchase an option, who is the party on the other side of the transaction?

More than likely, it's someone who engages in a highly speculative area of investment activity known as option "writing." Such investors are also sometimes called option "grantors." They stand to make money if, and only if, your option rights at expiration are worth less than you paid for them. In contrast to the limited risk that's involved in buying option, writing options involves potentially unlimited risks and should be thoroughly discussed with your broker. top

22. Who assures payment on exchange-traded option contracts?

When an option that you've purchased becomes profitable, the funds needed to pay you are collected (from the option writer on the other side of the transaction) on a daily basis. This is accomplished through the brokerage firms and the clearing organizations of the exchanges where options are traded.top

23. What brokerage commissions are involved in buying?

Brokerage firms differ in the services they provide, in their success in helping clients identify potentially profitable investment opportunities, and in the commissions that they charge. Provided commissions are stated in a clear and forthright manner, each firm can set its own rates - the same as firms in the securities industry do. Nevertheless, commissions are one variable in an option's profit equation and you should be satisfied that they are fair and reasonable in relation to the services and advice being provided.top

24. What place do options have in an overall investment program?

To start with, it should be said again that options have no place at all unless some portion of your total investment capital can legitimately be considered risk capital - money you can afford to take calculated risks with in pursuit of a correspondingly larger profit potential. If that requirement is met, options might very well have a worthwhile place in your total investment program. While options aren't for everyone, a study by John Lintner, Ph. D., of Harvard University found that including futures investments in a diversified stock and bond portfolio had the result of "reducing volatility while increasing return." top

25. How do options compare with other investments that involve similar risk and reward?

Obviously, no two or more investments have exactly the same risk-reward characteristics. One characteristic of options is that, to be profitable, the anticipated price movement has to occur within the time frame of the particular option you've selected. Having said this, however, options have a number of distinct advantages in addition to their limited risk. These include: top

         The opportunity to profit whether the price of a given commodity is expected to go up (by buying calls) or go down (by buying puts). This advantage should be readily apparent to investors who have had recent and frequent reminders that prices in a dynamic economy can move sharply downward as well as sharply upward. Option profits can be realized in both environments as easily in one as in the other.

         Diversification. Because of the leverage options provide, a given sum of investment capital can more readily be divided among a number of different market sectors simultaneously, such as oil, metals, and livestock. This diversification can improve your likelihood of "being in the right place at the right time."

Options may be the least expensive way to acquire an interest in just about any of the commodities on which options are available. For example, buying call options in anticipation of rising energy or livestock prices may be considerably less costly than the alternative of, say, purchasing an interest in oil wells or a cattle feedlot. top

26. Investment experts mention the "positioning" advantage of options. What exactly do they mean?

That's probably the best question with which to conclude because it's of key importance. It has to do with the well-known fact that major price movements, the kind that can make options especially profitable to own, frequently occur in response to specific economic or political events that may be anticipated but that can't be predicted with absolute certainty. Yet once these events do occur, there may be little or no opportunity for small investors to participate in the resulting price movement.

Example: A decision, yes, or no, by the Federal Reserve on some important issue can have a sudden and dramatic impact on interest rates, gold, the stock market, and currency values. An announcement of new trade rules can trigger a sharp movement in prices of agricultural commodities. An action by OPEC or an escalation of hostilities can send oil prices soaring or nose-diving.

A principal attraction of options, some say the principal attraction, is that they provide a way to "position" yourself to profit on a highly leveraged, ground-floor basis if and when the anticipated events and price movements occur, and to do so with the knowledge that the most you can lose if you are wrong is the cost of an option. top

In closing

The foregoing is, at most, a brief and incomplete discussion of a complex topic. Option 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 Options Disclosure Document that he is required to provide. In addition, have your broker at ExpressFutures.com provide you with educational and other literature prepared by the exchanges on which options are traded. A number of excellent publications are available.

In no way, it should be emphasized, should anything discussed herein be considered trading advice or recommendations, that should be provided by your broker or advisor. Similarly, your broker or advisor, as well as the exchanges where options contracts are traded, are your best sources for additional, more detailed information about options trading.


 



TRADING FUTURES AND OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.