When you decide that you want to buy an option, there are several questions you’ll want to have answered. The first one usually is “how much is it going to cost?” The answer (the amount of money) is called the premium. Premiums vary because of several different factors. Since you’re buying time when you buy an option, the first ingredient in premium, or price, is the amount of time you want to purchase. The longer your option will last, the more expensive it will be. Most of us are tempted at the time of purchase to skimp on time in order to save a few dollars. Except in rare circumstances, you should opt for the higher priced, longer term option. As in every other economic venture, you get what you pay for. A most frustrating trading experience is to call the market correctly only to run out of time before the big move.
Since options in commodities are standardized, you will only be allowed to buy or sell at predetermined price levels. Those price levels are called Strike Prices. The cost of the strike price is determined by how far it is in or out of the money. In the money refers to a call option with a strike price below the current market or a put option with a strike price above the current market quote. The premium consists of two parts - intrinsic value and time value. Intrinsic value is the portion of the premium that is represented by real market value (the amount that it’s in-the-money). Time value is the portion of the premium that is represented by the amount of time left until the option’s expiration.
As an option moves into the money it begins to exchange time value for intrinsic value. This value substitution keeps the option from appreciating at a rate equal to the underlying futures market. At-the-money would indicate that the current market and the strike price are the same. When the option is at the money it appreciates at about 50% of the rate of the underlying futures contract. As the market moves positively into the money, the option appreciates at a higher rate. Eventually, the intrinsic value replaces all of the time value and the option and futures appreciate and depreciate at the same rate. Obviously the opposite is true if the market moves negatively away from the strike price.
Market Movement & Volatility
Intrinsic value, that part of the option premium that represents real market value, increases as the futures market moves farther into the money. It is only market movement in the money that changes intrinsic value.
Time value is influenced by three factors. Of course the first and most obvious is the amount of time remaining until expiration. Another factor that affects time value is volatility. Volatility is the fear factor in option trading. When markets become dangerously wild the volatility can sometimes become as large a part of the time value equation as the time itself. That is because the option sellers realize that it has become much more difficult to estimate accurately the amount of risk in a fast moving market. Since they are responsible for paying off the winning option buyers, they know that they must collect more premium at the outset, “just in case.” The third force affecting time value is the distance between the market price and the strike price. The closer the market is to or the farther it is through the strike price, the more value an option has. The farther away from the strike the market is the less value it has.
Once you understand these basics it becomes much easier to recognize opportunities in the Option Market.
For instance, if I wanted to buy a Crude Oil call option but my spending limit is just $500, I would need to decide whether it might be better to buy a call close to the strike price with very little time until expiration or opt for one much farther away from the strike that would give me more time. There are also other possibilities available that involve option combinations that are in the Part 4 below.
Usually when we consider an option transaction we look to buy or sell a single strike price. For instance, if we think Gold is going to go to $720 per ounce in the next few months and it is currently trading at $680 per ounce, we would begin to check prices on Call Options starting at the 680 strike and then moving on up until we find one that fits our pocket book. We would also compare the cost of these options for different lengths of time.
For the sake of discussion, let’s say we have $1000 to spend on this investment. We find that we can buy an August 700 call, ($20 out of the money) for $1000. We think Gold will go to $720 but we’re concerned that it might not make it that high before August expires. If it does, our option should be worth at least $2000 (double our money). When we check the price for a December Call Option we can’t find anything realistically close to the current market for $1000.
This is a perfect time to find a combination that will allow us to benefit from the upward movement that we expect. Since the market is currently priced at 680 we look at a December 680 call first. It is quoted at $2650, a price that is way beyond our budget. However, when we look at a December 710 call we see that it is priced at $1850. That means that if we buy the 680 call and then sell the 710 call at the same time, we can apply the $1850 from the sale of the 710 call to the $2650 cost of the 680 call.
By doing it this way we have allowed ourselves to be long an option that is “at the money” ($10 closer to the money than the August) and with a four month longer life than the August. We are also within our budget because the difference between our purchase price and our sell price is only $800 plus two commissions. We still need to predict the direction of the market correctly, but we have increased our odds of winning significantly.
Let’s compare the August 700 call to our combination trade if the market does go to $720 per ounce. The August call at $720 will be worth $2000 plus any time value that is left if it reaches that goal before expiration. $2000 value minus the $1000 cost leaves us with a $1000 return. If time runs out before the market makes its move, the option finishes worthless. If the Gold market goes higher than 720 during the allotted time period, the option will appreciate $100 for each dollar above $720 at expiration.
The Combination, if it expires at $710 per ounce or above will be worth $3000 (the difference between 680 and 710), but no more no matter how high Gold goes. $3000 minus the $800 cost leaves us with a $2200 return. Not only that, but we have had an extra four months to realize our goal and by being able to be long at the money rather than $10 out of the money, our probability of success was greatly enhanced. Finally, the option would only need to expire above $710 per ounce for us to collect the full amount.
Hedging Your Position in a Wild Market
This last year has been a volatile one in several of the favorite commodity markets. When the markets are wild like this they are very interesting, but too crazy to trade with outright futures contracts. Many of you have started to use the options market to reduce your exposure and still have a chance to participate in the awesome moves.
For those of you who are unfamiliar with options, here is a 10 second explanation. Options can be purchased. When you buy an option you are buying the right to buy or sell a specific commodity at a specific price for a specific amount of time. A call is the right to buy and a put is the right to sell. The strike price is the price agreed upon and the premium is the cost of purchase.
When you purchase a call or put the amount of the premium is typically considered to be the risk. That allows you to trade with a good grasp on what your maximum risk will be.
I have found that most traders have a strong opinion about where their market of choice will go. That makes it easy for them to sometimes spend substantial amounts of money for their option positions. If the market does what is expected, there will be plenty of money to go around. The trader goes home happy.
Sometimes it doesn't work that way. Because of that it has been my recommendation for many years that traders spend some of their trade dollars for insurance. The way to do that is to invest 80% of the allocated funds on the investment and the other 20% on options that will win if the market goes the other way.
For an example, if you thought Gold was going to go from $650 to $750 per ounce you could buy 5 December 650 calls for $1000 each. If you are right, you make $50,000. If not, you could lose $5,000.
If, however, you only bought 4 December 650 calls and spent the other $1000 on 1 December put, you would make $40,000 - $1000 for your insurance. Not bad but not as good as $50,000. The difference is that if the market decided to go down to 600 instead, (which it will sometimes do), the $1000 spent on the put will be worth $5000 and the money spent on the investment will be available for some other opportunity.
This is a simple ploy that I think every option buyer should use whenever they make an option purchase. It will pay off more often than you think.
There is a risk of loss in trading futures and options. Past performance is not indicative of future results. Stops become market orders once the price is touched or violated; therefore, stops do not guarantee a fill at the price on the ticket. The information and data on this site was obtained from sources considered reliable. Their accuracy or completeness is not guaranteed and the giving of the same is not to be deemed as an offer or solicitation on our part with respect to the sale or purchase of any securities or commodities. Any decision to purchase or sell as a result of the opinions expressed on this site will be the full responsibility of the person authorizing such transaction.