Options on futures open the door to a host of versatile, economical trading strategies, strategies can be found to cover virtually any risk profile, time horizon, or cost consideration.
Because the underlying instrument of an options contract is a futures contract for a specific commodity, market participants can use options to cover themselves against volatile swings in futures prices, just as futures can be used to protect against volatile moves in prices of the underlying physical commodities.
WHAT IS AN OPTIONS CONTRACT?
There are two types of options:
Call: A call gives the holder of the options contract the right, but not the obligation to buy the underlying futures contract.
Put: Conversely, a put gives the holder the right but not the obligation to sell the underlying futures contract
The price at which the underlying futures contract may be bought or sold is the exercise price. An options contract affords the right to buy or sell for only a limited period of time; each options contract has an expiration date.
On the opposite side, a seller, or a writer of an options contract incurs an obligation to perform should an options contract be exercised by the purchaser. The writer of a call incurs an obligation to sell a futures contract and the writer of a put has an obligation to buy a futures contract.
OPTIONS RIGHTS AND OBLIGATIONS
Buyer: Has the right to buy a futures contract at a predetermined price on or before a defined date.
Seller: Grants right to buyer, so has obligation to sell futures at a predetermined price at buyer’ sole option.
There are four major factors affecting the price of an options contract:
The price of a futures contract relative to the options strike price.
Time remaining before options expiration.
Volatility of underlying futures price.
An options contract is a wasting asset. It has an initial value that declines, or wastes away, as time passes. Depending upon the movement of an options price, the buyer will choose one of three alternatives for terminating an options position:
Exercise the options contract.
Liquidate it by selling it back on the Exchange
Let it expire.
WHAT IS THE LEVERAGE ?
Leverage can amplify the potential gain from an investment by initiating a relatively small amount of money for the right to potentially capitalize on a much larger amount of capital or product.
These types of financial instruments however, carry a higher degree of risk.
Purchasing option contracts can provide investors unlimited profit potential with a risk limited to the total amount invested.
STRIKE PRICE VS FUTURES PRICE
Depending upon the futures prices relative to a given strike price, an options contract is said to be in-the-money, or out-of-the-money. An options contract is at-the-money when the strike price is the closest to the price of the underlying futures contract.
An options contract is considered in-the-money when the price of the futures contract is above a call’s strike price, or when the futures price is below a put’s strike price.
When the October heating oil futures price is 72¢ per gallon, the October 70¢ call is in-the-money. It grants the holder of the options contract to buy an October futures contract at 70¢ per gallon even though the market is at 72¢. Therefore, the call is automatically worth at least 2, per gallon; and is said to have an intrinsic value of 2¢ per gallon.
A put is in-the-money when the underlying futures price is less than the put’s strike price. If the September gold futures contract is $280 per ounce, a September $290 put is in-the-money. It gives the holder of the options contract the right to sell a futures contract at a price of $290 even though the market is trading at $280, giving the options contract an intrinsic value of $10.
When December natural gas futures price is $5.50 per million British thermal units, the December $5.65 call is out-in-the-money. It grants the holder of the options contract the right to buy a December futures contract at $5.65 per million But even though the market is at $5.50. Therefore, the call has no intrinsic value.
A put is out-of-the-money when the underlying futures price is higher than the put’s strike price. If the March copper futures contract at 76¢ per pound, a March 69¢ per-pound put is out-of-the-money. It gives the holder of the options contract the right to sell a futures contract at a price of 76¢, but since the market is trading at 69¢, it is unlikely the options contract would be exercised since it has no intrinsic value.
An option’s premium will usually equal or exceed whatever intrinsic value the options contract has, if any For example, if a crude oil options contract is in-the-money by $1 per barrel, its premium will almost always be at least $1.
The time premium for the in-the-money options contract is the amount that exceeds the option’s intrinsic value and reflects the possibility that the options contract may move deeper into-the-money.
The time value of an options contract shrinks as the expiration date approaches, with less and less time for major change in market opinion, and a decreasing likelihood that the options contract will increase in value.
As prices fluctuate, more widely and frequently, the premiums for options on futures increase, since the probability of the options contract attaining intrinsic value or moving deeper into the money increases. Accordingly, options writers demand higher premium payments. If market volatility declines, premiums correspondingly decline.
FUTURES OR OPTIONS?
Volatility: measures the market’s movement within a price range; the direction of the range is irrelevant.
Historical volatility indicates how much prices have changed in the past and is derived by using daily settlement prices for futures. Implied volatility, derived by using the option’s premium, measures how much the market thinks prices will change in the future. As volatility increases, so does the value of options, all else remaining equal – for example, the premium for at-the-money $260 gold call options with 90 days to expiration will increase dramatically with incremental increases in volatility.
As prices fluctuate more widely and frequently, the premiums for options on futures increase, since the probability of the options contract attaining intrinsic value or moving deeper into the money increases. Accordingly, options writers demand higher premium payments. If market volatility declines, premiums correspondingly decline.
Interest rates have a bearing on options prices because they represent the profit or cost that could result from an alternate use of the funds used for the premium.
Interest Rates: A change in interest rates influences the net present value calculation of a premium, the cost of buying and storing a commodity, and even the commodity price.
Most of the interest rate effect will already be incorporated in the futures price through the cost of carrying the physical commodity.
Buying Options “Going Long”
Options strategies based on long positions are most effective when sharp moves are expected, or unlimited margin risk cannot be tolerated by the trader.
Selling Options “Going Short”
A trader can also profit from selling, or writing, options. The options writer collects the premium and is obligated to perform should the buyer exercise his option. If the buyer does not exercise his option contract, the seller retains the premium. Because the options writer’s risk is potentially unlimited, short strategies that are not hedged are appropriate only for those willing and capable of assuming substantial risk.
As long as the buyer has no incentive to exercise his options contract, the writer profits. For commercial users, selling options helps offset inventory carrying costs by generating premium income. By accepting the premium, the trader augments his current income and has downside protection equal to the premium.
While futures offer price protection by allowing the holder of a futures contract to lock in a price level, a major appeal of options is that the holder of an options contract is afforded price protection, but still has the ability to participate in favorable market moves. Because the buyer of an options contract has the options contract but not the obligation to perform, he incurs no expenses beyond the initial premium. Therefore, if the market moves against a position, and a trader holds on to this option, the maximum cost is the price he has already paid for the option. On the other hand, if the market moves in favor of a position, the virtually unlimited profit potential to the buyer of an options contract is parallel to a futures position, net of the premium paid for the options contract.
Therefore, protection from unfavorable market moves is achieved at a known cost, without giving up the ability to participate in favorable market moves.
While the loss that can be incurred on an options contract is limited to the premium, the loss that can be incurred on an options contract is limited to the premium, the loss that can be incurred on a futures contract is the opportunity cost resulting from locking in a price and forfeiting the benefits of favorable market moves. Although options and futures are by necessity closed related, they are not interchangeable. Each has advantages and disadvantages and can be used separately or in combination to achieve a variety of risk management and investment objectives.
SELECTING A STRATEGY
Ultimately, a trader’s objectives, views of the market, and ability to carry risk will determine which strategy to use.
Risk: Unlimited risk on long and short positions
Price: Establishes fixed price protection
Margin: Required on long or short positions
Hedging: Long, short, spread
For example: an oil refiner buying crude oil is exposed to the risk of rising crude prices, and benefits when raw material prices decline. The less costly the crude, the lower the manufacturing costs will be. In order to protect against crude oil costs increases, the refiner can either buy a crude oil futures contract or buy a crude oil call options contract.
Assume that the crude market is trading at $27 a barrel, but the refiner fears that prices may increase for his crude oil requirements in the next quarter. He could buy $27 calls for each of the three months involved for 70 ¢ a barrel, or $700 per contract (each contract is for 1,000 barrels), plus transaction costs. If the price climbs to $30 per barrel, the refiner has earned $3,000 per contract ($3 per barrel on 1,000 barrels), less the $700 premium he paid for the call, for a net gain of $2,300. This gain would offset $2.30 of the $3-a-barrel increase in his cash crude costs.
What if crude oil prices fall? Because the holder of an options contract has a right and not an obligation, if price of crude oil falls to $25 per barrel, the refiner would let the options contract expire and buy his cash crude oil requirements at the lower, more favorable market price.
For comparison, assume that the refiner hedges his position only with futures. He buys crude oil futures at $27 and the market rises to $30. In that case, his profit on the futures position (excluding transaction costs) would be $3,000 or $per barrel, which would fully offset the increase in his cash crude costs. However, if the price falls to $25 per barrel, the refiner would have locked in his cost at $27 per barrel and forfeited the lower, more favorable market price. The futures-only position gives him a stable oil acquisition cost – $27 – no matter which way prices move, at the cost of forfeiting ability to participate in a decline in his raw material prices.
Likewise, a jewelry manufacturer who uses gold is exposed to the risk of rising metals prices, and benefits when gold prices decline. In order to protect against cost increases, the manufacturer can either buy a gold futures contract or buy a gold call options contract.