This article discusses the things you need to know about to profit from commodity options trading.
These key points will help you trade more successfully:
- Commodity Option characteristics
- Commodity Options Trading Basic Terms
- Commodity Options Trading Analysis
- The Greeks
1. Commodity Option Trading Introduction
What Are Commodity Options?
An option is a contract that gives you the right, but not the obligation, to either go long or go short the underlying futures contract at a pre-determined entry price on or before a specific date. It lets you take advantage of price moves in the futures markets without actually having a futures position.
There are two types of options, Call options and Put options.
The Call option gives you the right, but not the obligation, to go long the underlying commodity futures contract at a pre-specified entry price on or before a specific date. You would buy a Call option when you believe the futures price will increase.
A Put option gives you the right, but not the obligation, to go short the underlying commodity futures contract at a pre-specified entry price on or before a specific date. A Put option is used when you believe the futures price will decrease.
Commodity Option characteristics
Buying commodity Options have several characteristics which make them more attractive to traders. They include:
- Limited Risk. You cannot lose more than the amount paid for the option.
- Staying Power. You don't run the risk of getting stopped out of a trade.
- Profit Is Not Limited. If correct in your analysis, profit potential is not limited.
- Quick Fills. You can quickly enter and exit markets at a reasonable price.
- No Margin Calls. You won't encounter a margin call on option positions.
- No Limit Moves. Options are immune from the risk of limit moves.
- Numerous Strike Price Selections. Options are available in a range of strike prices.
- Lower Capital Requirements. Buying an option is less than the futures margin cost.
- * Provide Trading Alternatives. Options can be used as a substitute for protective stop.
2. Common Options Basic Terms
The following terms are commonly used in option trading.
The “strike price" is the price that you may enter the underlying futures contract if you exercise the option. For Call options, the strike price is the entry price that has the right to go long the underlying commodity futures contract. For Put options, this is the entry price at which one has the right to go short the commodity.
The “option premium" is market-determined price of the option that you pay to purchase either a call option or a put option. It is a non-refundable cost that the option seller keeps, and is your maximum amount of risk in the market. The premium is quoted just like the price of the underlying futures contract; in cents, points, etc. Option premiums fluctuate daily due to market conditions.
Options have two separate components which together define the option's premium. They are time value and intrinsic value.
"Time value" is the amount of time remaining before the option expires. “Intrinsic value" refers to how much the price of the underlying futures price is, relative to the strike price of the option. The option will have intrinsic value when the price of the futures contract is higher than the strike price of a call, or when the price of the futures contract is lower than the strike price of a put. Options with intrinsic value are referred to as in-the-money options.
All options are assigned an “expiration date" after which they are no longer valid for trading purposes. This is the last day that the option may be exercised. Frequently, this date will be 2-4 weeks before the underlying futures contract's Last Trading Day (LTD), although some futures items synchronize the option expiration date with the futures contract LTD. The farther out into the future an option's expiration date is, the more expensive the option will be (time = money).
3. Commodity Options Trading Analysis
First, you must analyze the futures market to identify the current (and likely future) price trend. My complete Commodity FUTURES Trading Course gives you the tools to help you intelligently analyze the futures markets and identify options which have a high probability for profit. This is what losers don't do. There will be times when your analysis suggests that a commodity is ready to start a major move. But the margin may be too large, or it may be volatile and the futures contract may require a large stop-loss risk amount ($1,200 to $2,500 or more) to avoid getting easily stopped out and is an amount which your money management rules prohibit. In other instances, the margin may just be too high. In these cases, you can use an option if your money management rules permit its purchase.
Practical Rules for Selecting Options
After you have analyzed the markets, you must first determine how much you want to risk. Your money management plan will be part of this determination. You should also consider the margin required for a futures contract as compared to the premium paid for the option. With commodity futures contracts, the margin is a refundable deposit - if you are correct about the direction of the move. With options, the premium is a non-refundable cost. For speculators, options work best in volatile markets because you don't get stopped out. They give you “staying power" - for a price.
Use the following items as a guide to help you in selecting a simple option position.
- The option type (will you be trading a call option or a put option)
- Buy an option with as close to 3 months before expiration as possible.
- Buy an option within 3 strike prices away from being in the money.
- Never risk more than $300 of the premium paid for the option.
- When possible, buy an even multiple of options (i. e. , 2, 4, 6, 8 options, etc. )
4. The Greeks
The term “greeks" is used to describe specific data values which are used by professional traders to analyze options. Top option traders know how changes in the greeks will affect the profitability of their trades and adjust their trades accordingly. This information will help you define the risk of an option trade. The expected profit or loss of an option is based on changes in market price, time until expiration, as well as changes in implied option volatility.
Note: The only way to get the greeks for individual options or for option spreads is to use an option software program such as OptionVue, or from a broker who uses one. Manually calculating these values daily is too cumbersome.
Delta tells you how much of a change to expect - either an increase or decrease - in the option's premium when the underlying futures price moves. The expected price change in the option's premium is expressed as a percent of the change in the price of a full futures contract. The Delta of an option is not fixed, but changes with variations in the futures price. As the futures price gets closer to the strike price, the value of Delta increases.
The Gamma tells you how much the option's Delta will change when the underlying futures price changes. As the futures price moves, the Delta changes, and Gamma can tell you how much change to expect in the Delta. If you start out with a Delta of 0.50 in a call option, a rally in the underlying futures price will cause Delta to increase.
Gamma tells you how much you would expect Delta to change on a 100 point move in the futures. Gamma will always be positive if you are long premium in either calls or puts, and negative if short.
This value tells you how much the option's price will decline in one day if the future price does not move at all. It is a reflection of time value loss and is expressed as a dollar amount. Theta is a variable that can be affected either by changes in the futures price, time left until expiration, and changes in implied volatility.
This value tells you how much the option price will change if implied volatility changes. It is the “sensitivity" of the option's price to volatility. Vega is expressed as a dollar amount. A positive Vega indicates that a rise in implied volatility will benefit your position. Vega tells you how much you can expect the theoretical value of an option to change based on a 1 percent change in implied volatility.
Special Note: There is substantial risk in trading commodity futures and options.
(C) 2008 Thomas Wnorowski
Thomas Wnorowski's flagship site Learn Futures contains contains 15 years of insight and techniques. His Commodity Futures Trading Course and Bullseye Commodity Trader Newsletter are tools you can use to educate yourself on Commodities and Options Trading.