A Brief Introduction to Options

The world of options is diverse and cannot be given justice in a short article such as this.  The purpose of this writing is to simply introduce the topic.  Should you be interested in getting involved or learning more, please consider purchasing "Commodity Options" published by FT Press at www.CommodityOptionstheBook.com.

Why Trade Commodity Options?

Just as there are several ways to skin a cat, there are an unlimited number of ways to trade in the options and futures markets.  The method that you choose should be based on your personality, risk capital and risk aversion.  Plainly, if you don't have an aggressive personality and a high tolerance for pain, you probably shouldn't be employing a trading strategy that involves elevated risks.  Doing so will often results in panic liquidation of trades at inopportune times as well as other unsound emotional decisions.

Commodity options provide a flexible and effective way to trade in the futures markets.  Options offer investors the ability to capitalize on leverage while still giving them the ability to manage risk.  For example, through the combination of long and short calls and puts an investor can design a strategy that fits their needs and expectations; such an arrangement is referred to as an option spread.  Keep in mind that the possibilities are endless and will ultimately be determined by a trader's objectives, time horizon, market sentiment and risk tolerance.

What is an Option?

There are two types of options, a call option and a put option.  Understanding what each of these is and how they work will help you determine when and how to use them.  The buyer of an option pays a premium (payment) to the seller of an option for the right, not the obligation, to take delivery of the underlying futures contract (exercise).  This financial value is treated as an asset, although eroding, to the option buyer and a liability to the seller. 

There are two sides to every option trade, a buyer and a seller.  Traders that are willing to accept considerable amounts of risk can write (or sell) options, collecting the premium and taking advantage of the well-known belief that more options than not expire worthless.  The premium collected by a seller is seen as a liability until the option is either offset (by buying it back), or it expires.

• Call Options – Give the buyer the right, but not the obligation, to buy the underlying at the stated strike price within a specific period of time.  Conversely, the seller of a call option is obligated to deliver a long position in the underlying futures contract from the strike price should the buyer opt to exercise the option.  Essentially, this means that the seller would be forced to take a short position in the market upon expiration.

• Put Options – Give the buyer the right, but not the obligation, to sell the underlying at the stated strike price within a specific period of time.  The seller of a put option is obligated to deliver a short position from the strike price (accept a long futures position) in the case that the buyer chooses to exercise the option.  Keep in mind that delivering a short futures contract simply means being long from the strike price.

	Call	Put
Buy			Limited Risk
Sell			Unlimited Risk

When to use Options?

Options can be useful in any market environment using option spreads or even simple long or short calls and puts.  However, we believe that the best option trading opportunities present themselves during times of extreme prices. 

In our opinion, commodity markets coming off of long-term highs or lows typically present traders with an extraordinary prospect.  However, it is important to realize that just because a commodity seems "cheap" doesn't mean that it can't go lower.  Likewise, while we would never advocate buying (or being bullish with options) a commodity at an all time high, it is always possible that prices can continue higher.  If you were trading the 2007/2008 commodity rally, or the 2008 Treasury rally you know exactly what I am talking about. 

Whereas price extremes have no boundaries, they don't last forever, eventually supply and demand factors will bring prices back to a more equilibrium state.  Accordingly, while caution is warranted at extreme levels it is often a good time to be constructing counter trend trades as it could be one of the most advantageous times in history to be involved in a market.  Once again, your personal situation would determine whether an unlimited risk or limited risk strategy should be utilized.  Please realize that identifying extreme pricing scenarios is easy, it is much more difficult to predict the timing necessary to convert it into a profitable venture.

In search of a promising commodity option trade, it is important to look at whether or not the options are priced fairly.  Option prices fluctuate according to supply and demand in the market.  At times, prices become inflated or undervalued relative to theoretical models such as Black and Scholes.  For example, during the "crash" of 2008 the value of put options exploded as traders scrambled to buy insurance for their stock portfolios or simply thought that the equity market would go down forever.  The increase in option premium was partly due to inflated volatility but increased demand for the instruments had a lot to do with it.  Those that chose to purchase put options at inopportune times and at overvalued prices, likely didn't fair very well. 

To reiterate, buying options in times of low volatility could prove to be advantageous should the volatility increase sharply.  On the other hand, a lack of deviation in the price of the underlying asset will produce lower market volatility and even cheaper option premiums.  Once again, pricing is relative and dynamic; "cheap" doesn't mean that it can't get "cheaper".

Open your Mind to Option Selling

It has been suggested by several conducted studies, including one by the Chicago Mercantile Exchange, that far more options than not expire worthless.  Using this assumption, we believe that in many circumstances it may be advantageous to be a net option seller.  

For instance, it is possible to construct an option strategy that is affordable without sacrificing the odds of success...but with the convenience comes theoretically unlimited risk.  This is easier than it sounds, similar to the way you would borrow money to pay for a house or a car, you can borrow money from the exchange to pay for long option trades.  There are an unlimited number of combinations of self-financed trades but they are typically going to involve more short options than long, or at least as much premium collected on the sold options than that paid for the longs.  In essence, the money brought in through the sale of the short options goes to pay for the options that are purchased.  The result is a relatively close-to-the-money option with little out of pocket expense but theoretically unlimited risk beyond the strike price of the naked short options.

Conclusion

Options are exactly what the name implies, they give traders "options" in that they are capable of being used in nearly every scenario and with variable risk and reward profiles.  Too many traders fail to tap the true potential and flexibility of option spreads due to their seemingly complex nature; however, things aren't always as they appear.  We strongly believe that you owe it to yourself to overcome your fear of options and open your mind to the possibilities. 

*Futures and Options Trade Involves Substantial Risk of Loss and is Not Suitable for All Investors.

Carley Garner

1-866-790-TRADE

cgarner@decarleytrading.com

Carley Garner is the Senior Analyst at DeCarley Trading LLC where she also works as a broker.  Her book, "Commodity Options" published by FT Press is now available through all major book outlets. Visit www.DeCarleyTrading.com for your free subscription to Carley's e-newsletters and for details on the services she provides.