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.
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
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
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
Other advantages include:·
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.
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
Just a couple. You should know what's meant by an option's "premium"
and by its "strike price."
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
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
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
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):
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
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:
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
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
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
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
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
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
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
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
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
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
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
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
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
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.
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.
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
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
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
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
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 Heritage West Financial 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.
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Questions? Speak with a Heritage West Professional
Heritage West Financial, Inc.
8775 Aero Dr., Suite 302
San Diego, CA 92123
Local: (858) 560-2646
Toll Free: (800) 263-3004
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.