Money: The Futures Options

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To the dismay of many a commodity broker and trader, disinflation and disaffection have reduced trading volume on American futures markets since the halcyon days of the late '70s. We are now witnessing a period of consolidation, but more important, one of innovation. As less-successful contracts are weeded out, a more-permissive Commodity Futures Trading Commission (CFTC) is allowing the development of new futures instruments, such as interest rate futures and stock index futures (see Money, Aug.) that will strengthen the "commodity" markets and in turn the nation's economic and financial infrastructure. Now, the CFTC is about to give the go-ahead for an exciting new speculative and hedging vehicle—options on futures contracts.

Since a futures contract enables one, in effect, to fix the price at which one may buy or sell a commodity in the future, what does an option on a futures contract mean? In return for a "premium," an option will entitle (but not oblige) the investor to buy or sell a futures contract at a specified "striking price" within a certain period of time.

The various options will generally be traded for expiration months corresponding to the delivery periods of the futures contracts on which they are written. At any given time, options with four expiration dates will be trading. For each month's option, several different striking prices will be established—above, at, and below the going futures price. These striking prices will be quoted in the same terms as the futures contract and will be changed as the futures price changes.

There are basically two types of options, of course: "calls," which entitle one to buy at a certain price within a certain period, and "puts," which entitle one to sell at a certain price within a certain period. Both types will be offered (for different expiration dates and striking prices).

The value of the option—the "premium"—will be set by the market and will be largely determined by the relation of the striking price to the actual futures price and by the distance from the expiration date. An option that is "in the money" (above the futures price in the case of a call, below the futures price in the case of a put) will obviously cost more than one that is "out of the money." The option buyer also pays for time, with the premium rising as the expiration date looms into the future.

Since, as with futures contracts, it takes two to make a trade, both put and call options can be either bought or sold. The option seller receives the premium paid by the option buyer. Within this four-way breakdown are an endless number of options trading strategies.

For the buyer (though not always for the seller, or "writer") of puts and calls, the beauty of options is the prospect of highly leveraged profits with finite risk. To take a very simple example, suppose you're bullish on the price of sugar come January, when sugar is trading at 12 cents per pound. You buy a July sugar option with an "at the money" striking price of 12 cents per pound.

The Coffee Sugar & Cocoa Exchange hypothesizes a $1,000 premium for this example. If, after a few months, sugar has risen to 15 cents per pound, your option may have risen in value to $3,360 (3 cents × 112,000 pounds).

You would then have several choices. You could take your profit by selling an offsetting July call. You could continue to hold the option in the hope that further price rises would make the option even more valuable—remembering that options tend to cheapen as the expiration date approaches. Or, you could even exercise the call, acquiring a long position in July sugar futures. If you were wrong about sugar and the price declined, the most you could lose would be the original $1,000 premium, and you could probably salvage some of that outlay, since options usually have some value until the day of expiration.

If you're bearish on a commodity, you might instead buy a put, entitling you to sell at a given price. If you buy a put entitling you to sell, say, July sugar at 12 cents and it goes to 9 cents sometime before expiration, your option will roughly reflect the value of that three-cent move ($3,360).

Just as puts and calls can be bought for limited-risk speculation, so they can be used for low-cost hedging. If one has a long position in futures, it might make sense to buy a put in the same futures contract at or above your entry price. If the price of the commodity you went long on moves up, your futures profit will have been diminished by the cost of the option premium, but if the market moves against your long futures position, then you'll be able to sell at little or no loss other than your options premium. A good insurance policy! Likewise, if you are short futures, you can hedge by buying a call.

An alternative to the buying of options for hedging is writing "covered" options. Options writing is actually a different ballgame and can be highly risky, but when "covered" by a futures position, it can be both safe and profitable. Writing a call is not a substitute for buying a put for the investor who is long futures, nor is writing a put a substitute for buying a call for the short futures trader. Instead, it is a means of enhancing one's futures profits, under the right conditions. For example, if you are about to go long or are already long a commodity in the futures market, the writing of a call can effectively raise your futures price (if prices go up) and cushion your losses if prices fall.

One need not have a futures position to write options any more than to buy options. One can write uncovered, or "naked," calls or puts on futures contracts either to make premium income or to place an option spread. But, unlike covered option writing, the potential risks here are as great as in futures themselves, minus only the premium income.

Although options are correctly reputed to be a limited-risk investment, this is really true only of buying options. When writing options, if the price moves adversely, you would have to put up additional margin money.

Yes, there are some risks, but they are mild compared to the unbridled futures markets—and milder still compared to the shrieks of terror emitted by the congressional and bureaucratic opponents of options. More important, options will make the futures markets safer, more sophisticated, and stronger.

Steven Beckner is a financial reporter and columnist for the Washington Times and the author of The Hard Money Book.

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  1. Though options trading are considered as a low-risk investment, however, you should know the right strategies before making an investment. As you have mentioned all the important factors here, it’s crucial for every trader to work on them and build profitable options portfolio.

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