February 7, 2014

By: Kevin Kerr, Managing Editor and Trader at CommodityConfidential.com

Few topics gloss over the eyes of new traders quicker than the subject of options.  Now, even advanced traders who are comfortable with various sectors of the markets may still avoid using options because of a certain comfort level.   So the best place to start to eliminate that fear is to define some basic terminology and strategy.  Now my examples in this article will be based on commodity options but the basic principles can really apply to any market. 

What’s the point of Trading Options?

Well the quick answer that most people would say is leverage.  In today’s growing and volatile markets capital has become scarce and having to put up all that capital can be quite costly.  Full margin is required for most trading these days and that can be a very expensive venture.  By utilizing options strategies you may be able to increase returns on capital overall.  In addition options trading allows more sophisticated trading modules and strategies.  Many traders also simply like the flexibility of options and being able to format the trade more to their objectives and specific outlook. 

Breaking Down Options

To keep it simple let’s just focus on the very basic principles of options.  First of all it’s important to have a handle on the basics.  So an option is the right to buy (calls) or sell (puts) at a set amount also called the (notional value) at a specified date in the future (the expiration date), at a specified price (strike price).  On the opposite side is the options seller (or writer of the option)  they in turn collect the premium in advance for selling the rights to the buyer.

For example a call option buyer is bullish. That is, he or she believes the price of the underlying futures contract will rise. If they are correct and prices do rise, the call option buyer has three different choices.

First the buyer can choose to exercise the option and in turn would get the underlying futures contract at the strike price. The second choice would be to offset the long call position with a sale and simply realize a profit. The third, and in my opinion the worst choice is to let the option expire worthless and forfeit the unrealized profit.

Now, on the other hand a seller of the call option expects futures prices to remain relatively stable or to decline slightly. So, If prices remain stable, the seller who got   the option premium enhances the rate of return on a covered position. If prices decline, selling the call against a long futures position enables the writer to use the premium as a cushion to provide downside protection to the extent of the premium received.

Now, like the rest of the commodities markets the price (value) of an option premium is determined competitively by open outcry auction on the trading floor of the Exchange.

The premium is determined by the number of buy and sell orders reaching the exchange.

An option buyer pays the premium in cash to the option seller (writer). This cash payment is credited to the seller’s account.

Never enough Time

As is true with so many things in life, with options there is simply never enough time, the clock is always ticking in other words. Time value is one of the most important factors in determining option premium.  Time value reflects the probability the option will gain in intrinsic value or become profitable to exercise before it expires.

Time value is determined by subtracting intrinsic value from the option premium:

Time value = Option premium – Intrinsic value

There are a myriad of other factors that also have an impact on the premium. One is the relationship between the underlying futures price and strike price. The more an option is in-the-money, the more it is worth.  A second factor is volatility. Volatile prices of the underlying commodity can stimulate option demand, enhancing the premium. The greater the volatility, the greater the chance the option premium will increase in value and the option will be exercised; thus, buyers pay more while writers demand higher premiums.

A third factor affecting the premium is time until expiration. Since the underlying value of the futures contract changes more within a longer time period, option premiums are subject to greater fluctuation.   This is the reason options with less time value are often a lot cheaper.

Spreading Your Wings

One strategy that in my opinion can be very useful during higher volatility times in the commodities markets, such as we are experiencing now, is option spreads.

Basically when you trades option spreads, what you’re doing is taking a simultaneous long and short position in an attempt to make a profit. The profit comes from the differential, or “spread,” between two prices. A spread can be established between different months of the same commodity (called an interdelivery spread), between the same or related commodities, usually for the same month (intercommodity spread), or between the same or related commodities traded on two different exchanges (intermarket spread). 

You can enter a spread order at the market or you can designate that you want to be filled when the price difference between the commodities reaches a certain point (or premium). Take this spread example: We want to buy 1 June crude oil  and Sell 1 August crude oil when the August crude oil contract is 100 points higher than the June contract. The order would read something like this:

BUY 1 JUNE CRUDE, SELL 1 AUGUST 

CRUDE PLUS 100 TO THE AUGUST SELL SIDE. 

Sounds confusing but it’s really not.   Again, all this means is that you want to initiate or liquidate the spread when the August crude contract price is 100 points higher than the June crude. These days, most exchanges don’t report spread transactions on their quote boards, but a few do. The best way is to find out from your broker who will call the trading floor or the order desk and ask them to get a “fresh quote.” Another way to figure out where a spread may be is to take the two prices and simply add or subtract one from the other. Always confirm this with your broker or the trading floor before entering any spread trade. 

Just like everything in commodities, after you get used to the basics of spreads you’ll become aware of more complex strategies that include but are not limited to things like: Condor spreads, Crack spreads, Crush spreads—etc.