Options on Futures -
The Pros and Cons of Trading Futures with Options
The Myth of Unlimited Risk Trading Options
If you are the buyer of the option (call or put), the
only money you risk is the premium paid to the seller. If you are the seller
of the option you could, in theory, have unlimited risk as
the price of a commodity could go to the moon. For example, if you
sell a 450 gold call option, you give the buyer the right to buy a futures
contract from you at a market price of $450, which he could immediately offset by selling a
futures on the market at "infinity".
Of course, the probability of gold going
up to "infinity" is impossible, so the risk isn't exactly unlimited, but you
get the idea. If you sold a 450 put option, you give the buyer of the option
the right to sell a futures contract to you at 450 (i.e. you have to buy it
from him at 450). If the price of gold fell to one cent, the buyer of the
option could sell a futures contract to you at 450 and immediately offset his
position by buying a futures contract at one cent. (You, as the seller, would
have to offset your position by selling at the market price of one cent).
Again, the chance of gold falling from $450/oz to $0.01 is virtually
impossible so your risk as the seller is greater in theory than in reality.
A call option buyer expects the underlying futures
market to go up. He buys a call option from the option seller to buy the
futures contract at a certain price... and if the futures market goes up
enough, he can offset the position by immediately selling the futures contract
for a higher price on the futures market.
If he thinks the price of the futures contract will go
up significantly, he could buy a deep out-the-money call option. For example,
Feb Gold futures are trading at 450. He thinks the price of gold will rocket
to 500 by the time the option expires in a few weeks time. He could buy Feb
500 call options for $300 each. If gold then went to 500, he could exercise
his option, buy a contract from the option seller at 450, immediately offset
it by selling a futures contract in the pits for the market price of 500 and
make $5000 per option (less commissions and the $300 paid in premium).
What if things didn't go as the call buyer planned? If gold
tanked, he would not exercise his option and he would only have lost the $300
in premium.
If gold did go up but not as far as he thought, say to
490, he would not exercise the option because he would make a loss of $1000
(buy at 500, sell in the futures market at 490, x Gold futures contract's $100/point).
Similarly, if gold stayed roughly the same, it would be
unlikely that he would
exercise his option as he'd lose the premium of $300/option.
The call buyer also has other choices he could
make. For
example, he could have played it a little safer and bought call options with
strike prices of 470. They'd be profitable if gold went to 470, not his higher
target of 500. Because there is a greater chance that gold would get to 470
rather than 500, the seller is entitled to more premium as his risk is
greater. The 470 Feb gold options might cost the buyer $1600 each.
Or, the trader is convinced gold will skyrocket but it
might take longer than he initially thinks. To give himself a bit more elbow
room, he might decide to buy the April gold 500 options, which would give him
a couple of extra months for gold to move as he anticipated. As there is more
time, there is more chance of gold reaching this level so the seller may be entitled to a greater premium of $2000 per option.
Looking at the above example from the view of the
seller: "This guy thinks gold is going to rise to 500! He must be insane!" You,
as the seller,
believe gold might go up a little, but will then settle at roughly the same
price. You can sell 500 Feb gold call options to this lunatic for $300 each.
The chances of him exercising the option are virtually non existent in your
opinion, and the $300/options is money in the bank.
If this guy thought gold was going to 470, you might think he was, not
quite a lunatic, perhaps a bit strange? Still there is a chance
that gold could go up $20/contract. To make the risk worth your while, you can
sell him call options for $1600 each. Again, you feel there is little chance
of gold getting this high, of him exercising the option, and this is easy
money for you to collect.
What if the trader had just bought futures contracts and
forgotten about the gold options? If he'd bought a Feb gold futures contract
at $450 and the market dropped to $430, he'd be down 20 x $100 = $2,000. With
his Feb gold options he'd only be down the premium of $300, worst case scenario. Gold
could drop to 350, then go up to 500 where he could exercise his option and
make a profit. At any time, he'd only be down $300 in option premium. With
buying a futures contract, he'd be down 450-350 = 100 points x $100/pt = $10,000.
So you see, in this case, the risk is less (and limited) buying an option.
However, if you trade futures, you do not have to pay
the premiums which can often be expensive if there is a reasonable amount of
time left before the contract expires, or if the strike price is near to the
current futures price. If you get a signal to buy gold futures but do not think it
will go that high, you may be better off buying a futures contract than a call
option.
For example, Feb gold is at 450 and you get a signal to
go long. Gold has been trending up for some time and you do not think it will
get much higher. But you want to stick to your trading system and go long. You
buy a Feb gold futures contract. All you pay is the commission charge (say of $20).
Gold futures go up to 455 and you place a stop loss at 450. Worst case scenario now
is that you exit the trade at the same price that you entered (less
commission, spread and slippage). Say this happens, you have broken even. If
you had bought a call option, you would have lost $300.
Say you didn't get stopped out and gold went up to 465.
You then got a signal to exit. You would make 450-465 = 15 points x $100/pt =
$1500. If you had bought the 500 or 470 call options,
you would not be able to exercise them for a profit unless gold got to
470 or 500. At this point you would still
be down $300 in premium on your call option as opposed to being up $1500 with
your futures trade.
Other pros and cons of options
Some futures markets have high volumes making it
possible to get fill prices near to where you want them to be, for example
near your stops. Futures markets with high volumes include S&P 500, NASDAQ,
Treasury Bonds, major currencies, crude oil and gold.
Other futures markets do not have as much volume and
this can sometimes make it difficult to get an order filled quickly. In a fast
moving market, this can make the difference of $100s of dollars on a trade.
For example, you are long Crude Oil with a stop loss at 41.20. The market
plunges through this level and you might get a fill at 40.80 including the
spread. This is a difference of 40 cents per contract and Crude trades at $10
per cent. Therefore, this has cost you $400.
If you had traded a thinner market such as Heating Oil,
which has volume approximately one-seventh that of Crude at the time of
writing, you might end up losing $1000 with a bad fill.
You should be aware that this problem can be greater
when trading options on futures as the markets are even less liquid. It might
take a while for your option order to be filled near the price you would like.
Conclusion
If your futures trading system is right most of the time
and gives you the chance to lock in a breakeven or profit, say 70% of the
time, you may be better off trading outright futures contracts than paying a
large amount in premium on options.
If your trading system is often right in the long-run,
but you regularly see the market move against you before you are proved right
(which can see a large drawdown with the high leverage of futures), you could
be better off trading options.
If your system times market break-outs accurately, then
buying options near to expiry might be a good idea. The premium will be low
and the payoff high in a short period of time.
If your system is good at finding markets that are
likely to congest, or are likely to slow in trend, then perhaps
writing/selling far out-the-money options might be a good strategy for you.
Chances are the market would not break to these price extremes, the buyer of
the option would rarely exercise his options, and you'd regularly take his
premiums, maybe 80% of the time or more.
How to Trade Options
If you want to trade commodity options with us, you can do so using the same
trading platforms as our futures
traders. J-Trader and Strategy Runner are designed for the customer who wishes
to trade the electronic markets, exclusively. AlarOnline is designed for
customers who will be trading pit traded contracts.
However, although you can demo trade
futures or forex with us, you cannot
demo trade options on any of our platforms.
Other Trading Articles
Futures Trading
Futures Trading
Learn the basics of trading commodity futures
Forex vs. Futures
Which should you trade? Forex or futures? Or Even Options on
Futures?
Futures and Options
Read our article describing the pros and cons of trading
futures with options
Online Futures Trading
An outline of the choices available when choosing an online
platform
Futures Trading Method
Day trading, tech, fundamental analysis
|
