Options 101
| Ch. 1: Vocabulary |
| Ch. 2: The Arithmetic of Option Premiums |
| Ch. 3: The Mechanics of Buying and Writing Options |
| Ch. 4: A Pre-Investment Checklist |
Keep yourself updated with Our Free eNewsletters!
Options 101 - Chapter 3 |
|
|
|
Introduction to Options Trading 101 Published By: National Futures Association Chapter 3: The Mechanics of Buying and Writing OptionsCommission Charges Before you decide to buy and/or write (sell) options, you should understand the other costs involved in the transaction—commissions and fees. Commission is the amount of money, per option purchased or written, that is paid to the brokerage firm for its services, including the execution of the order on the trading floor of the exchange. The commission charge increases the cost of purchasing an option and reduces the sum of money received from writing an option. In both cases, the premium and the commission should be stated separately. Each firm is free to set its own commission charges, but the charges must be fully disclosed in a manner that is not misleading. In considering an option investment, you should be aware that:
You should fully understand what a firm’s commission charges will be and how they’re calculated. If the charges seem high—either on a dollar basis or as a percentage of the option premium—you might want to seek comparison quotes from one or two other firms. If a firm seeks to justify an unusually high commission charge on the basis of its services or performance record, you might want to ask for a detailed explanation or documentation in writing. Leverage Another concept you need to understand concerning options trading is the concept of leverage. The premium paid for an option is only a small percentage of the value of the assets covered by the underlying futures contract. Therefore, even a small change in the futures contract price can result in a much larger percentage profit—or a much larger precentage loss—in relation to the premium. Consider the following example: An investor pays $200 for a 100-ounce gold call option with a strike
price of $300 an ounce at a time when the gold futures price is
$300 an ounce. If, at expiration, the futures price has risen to
$303 (an increase of only one percent), the option value will increase
by $300 (a gain of 150 percent on your original investment of $200).
But always remember that leverage is a two-edged sword. In the above
example, unless the futures price at expiration had been above the
option’s $300 strike price, the option would have expired
worthless, and the investor would have lost 100 percent of his investment
plus any commissions and fees. Before purchasing any option, it’s essential to precisely determine what the underlying futures price must be in order for the option to be profitable at expiration. The calculation isn’t difficult. All you need to know to figure a given option’s break-even price is the following:
Determining the break-even price for a call option Option Strike Price + Option Premium + Commission & transaction cost = Break-Even Price Example: It’s January and the 1,000 barrel April crude oil futures contract is currently trading at around $12.50 a barrel. Expecting a potentially significant increase in the futures price over the next several months, you de-cide to buy an April crude oil call option with a strike price of $13. Assume the premium for the option is 95¢ a barrel and that the com-mission and other transaction costs are $50, which amounts to 5¢ a barrel. Before investing, you need to know how much the April crude oil futures price must increase by expiration in order for the option to break even or yield a net profit after expenses. The answer is that the futures price must increase to $14 for you to break even and to above $14 for you to realize any profit. Option strike Commission & Break-even The option will exactly break even if the April crude oil futures price at expiration is $14 a barrel. For each $1 a barrel the price is above $14, the option will yield a profit of $1,000. If the futures price at expiration is $14 or less, there will be a loss. But in no event can the loss exceed the $1,000 total of the pre-mium, commission and transaction costs. Determining the break-even price for a put option The arithmetic is the same as for a call option except that instead of adding the premium, commission and transaction costs to the strike price, you subtract them. Options Strike Price - Option Premium - Commission & transaction costs = Break-even price Example: The price of gold is currently about $300 an ounce, but during the next few months you think there may be a sharp decline. To profit from the price decrease if you are right, you consider buying a put option with a strike price of $295 an ounce. The option would give you the right to sell a specified gold futures contract at $295 an ounce at any time prior to the expiration of the option. Assume the premium for the put option is $3.70 an ounce ($370 in total) and the commission and transaction costs are $50 (equal to 50¢ an ounce). For the option to break even at expiration, the futures price must decline to $290.80 an ounce or lower. Option strike Commission & Break-even The option will exactly break even at expiration if the futures price is $290.80 an ounce. For each $1 an ounce the futures price is below $290.80 it will yield a profit of $100. If the futures price at expiration is above $290.80, there will be a loss. But in no case can the loss exceed $420—the sum of the premium ($370) plus commission and other transaction costs ($50). Factors Affecting the Choice of an Option If you expect a price increase, you’ll want to consider the purchase of a call option. If you expect a price decline, you’ll want to consider the purchase of a put option. However, in addition to price expectations, there are two other factors that affect the choice of option:
The length of the option One of the attractive features of options is that they allow time for your price expectations to be realized. The more time you allow, the greater the likelihood the option will eventually become profitable. This could influence your decision about whether to buy, for example, an option on a March futures con-contract or an option on a June futures contract. Bear in mind that the length of an option (such as whether it has three months to expiration or six months) is an important variable affecting the cost of the option. A longer option commands a higher premium. The option strike price The relationship between the strike price of an option and the current price of the underlying futures contract is, along with the length of the option, a major factor affecting the op-tion premium. At any given time, there may be trading in options with a half dozen or more strike prices—some of them below the current price of the underlying futures contract and some of them above. A call option with a low strike price will have a higher premium cost than a call option with a high strike price because it will more likely and more quickly become worthwhile to exercise. For example, the right to buy a crude oil futures contract at $11 a barrel is more valuable than the right to buy a crude oil futures contract at $12 a barrel. Conversely, a put option with a high exercise price will have a higher premium cost than a put option with a low exercise price. For example, the right to sell a crude oil futures contract at $12 a barrel is more valuable than the right to sell a crude oil futures contract at $11 a barrel. While the choice of a call option or put option will be dictated by your price expecta-tions, and your choice of expiration month by when you look for the expected price change to occur, the choice of strike price is some-what more complex. That’s because the strike price will influence not only the option’s pre-mium cost but also how the value of the op-tion, once purchased, is likely to respond to subsequent changes in the underlying futures contract price. Specifically, options that are out-of-the-money do not normally respond to changes in the underlying futures price the same as options that are at-the-money or in-the-money. Generally speaking, premiums for out-of-the-money options do not reflect, on a dollar for dollar basis, changes in the underlying futures price. The change in option value is usually less. Indeed, a change in the underlying fu-tures price could have little effect, or even no effect at all, on the value of the option. This could be the case if, for instance, the option remains deeply out-of-the-money after the price change or if expiration is near. If you purchase an out-of-the-money option, bear in mind that no matter how much the futures price moves in your favor, the option will still expire worthless, and you will lose your entire investment unless the option is in-the-money at the time of expiration. To re-alize a profit, it must be in-the-money by some amount greater than the option’s purchase costs. This is why it’s crucial to calculate an option’s break-even price before you buy it. Example: At a time when the March crude oil futures price is $11 a barrel, an investor expecting a substantial price increase buys a March call option with a strike price of $12.50. By expiration, as expected, there has been a substantial price increase to $12.50. But since the option is still not worthwhile to exercise, it expires worthless and the investor has lost his total investment. After You Buy an Option, What Then? At any time prior to the expiration of an option, you can:
Offsetting the option Liquidating an option in the same marketplace where it was bought is the most frequent method of realizing option profits. Liquidating an option prior to its expiration for whatever value it may still have is also a way to reduce your loss (by recovering a portion of your in-vestment) in case the futures price hasn’t per-formed as you expected it would, or if the price outlook has changed. In active markets, there are usually other in-vestors who are willing to pay for the rights your option conveys. How much they are will-ing to pay (it may be more or less than you paid) will depend on (1) the current futures price in relation to the option’s strike price, (2) the length of time still remaining until ex-piration of the option and (3) market volatility. Net profit or loss, after allowance for commis-sion charges and other transaction costs, will be the difference between the premium you paid to buy the option and the premium you receive when you liquidate the option. Example: In anticipation of rising sugar prices, you bought a call option on a sugar futures contract. The premium cost was $950 and the commission and transaction costs were $50. Sugar prices have subsequently risen and the option now commands a premium of $1,250. By liquidating the option at this price, your net gain is $250. That’s the selling price of $1,250 minus the $950 premium paid for the option minus $50 in commission and transac-tion costs. Premium paid for option $ 950 Premium received when option is liquidated
$ 1,250 Increase in premium $ 300 Less transaction costs $ 50 Net
profit $ 250 You should be aware, however, that there is no guarantee
that there will actually be an active market for the option at the
time you decide you want to liquidate. If an option is too far removed
from being worthwhile to exercise or if there is too little time
remaining until expiration, there may not be a market for the option
at any price. Continuing to hold the option The second alternative you have after you buy an option is to hold an option right up to the final date for exercising or liquidating it. This means that even if the price change you’ve anticipated doesn’t occur as soon as you expected—or even if the price initially moves in the opposite direction—you can continue to hold the option if you still believe the mar-ket will prove you right. If you are wrong, you will have lost the opportunity to limit your losses through offset. On the other hand, the most you can lose by continuing to hold the option is the sum of the premium and transac-tion costs. This is why it is sometimes said that option buyers have the advantage of staying power. You should be aware, however, options decline in value as they approach expiration. (See "Time Value" on page 10.) Exercising the option You can also exercise the option at any time prior to the expiration of the option. It does not have to be held until expiration. It is es-sential to understand, however, that exercising an option on a futures contract means that you will acquire either a long or short posi-tion in the underlying futures contract—a long futures position if you exercise a call and a short futures position if you exercise a put. Example: You’ve bought a call option with a strike price
of 70¢ a pound on a 40,000 pound live cattle futures contract.
The futures price has risen to 75¢ a pound. Were you to exercise
the option, you would acquire a long cattle futures position at
70¢ with a "paper gain" of 5¢ a pound ($2,000).
And if the futures price were to continue to climb, so would your
gain. For all these reasons, only a small percentage of option buyers elect to realize option trad-ing profits by exercising an option. Most choose the alternative of having the broker offset—i.e., liquidate—the option at its cur-rently quoted premium value. Who Writes Options and Why Up to now, this booklet has discussed only the buying of options.
But it stands to reason that when someone buys an option, someone
else sells it. In any given transaction, the seller may be someone
who previously bought an option and is now liquidating it. Or the
seller may be an individual who is participating in the type of
investment activity known as option writing. Example: At a time when the March U.S. Trea-sury Bond futures price is 125-00, an investor expecting stable or lower futures prices (meaning stable or higher interest rates) earns a premium of $400 by writing a call option with a strike price of 129. If the futures price at expiration is below 129-00, the call will expire worthless and the option writer will retain the entire $400 premium. His profit will be that amount less the transaction costs. While option writing can be a profitable activ-ity, it is also an extremely high risk activity. In fact, an option writer has an unlimited risk. Ex-cept for the premium received for writing the option, the writer of an option stands to lose any amount the option is in-the-money at the time of expiration (unless he has liquidated his option position in the meantime by mak-ing an offsetting purchase). In the previous example, an investor earned a premium of $400 by writing a U.S. Treasury Bond call option with a strike price of 129. If, by expiration, the futures price has climbed above the option strike price by more than the $400 premium received, the investor will incur a loss. For instance, if the futures price at expiration has risen to 131-00, the loss will be $1,600. That’s the $2,000 the option is in-the- money less the $400 premium received for writing the option. As you can see from this example, option writ-ers as well as option buyers need to calculate a break-even price. For the writer of a call, the break-even price is the option strike price plus the net premium received after transac-tion costs. For the writer of a put, the break-even price is the option strike price minus the premium received after transaction costs. An option writer’s potential profit is limited to the amount of the premium less transaction costs. The option writer’s potential losses are unlimited. And an option writer may need to deposit funds necessary to cover losses as often as daily. Risk Caution Option writing as an investment is absolutely inappropriate for anyone who does not fully understand the nature and the extent of the risks involved and who cannot afford the pos-sibility of a potentially unlimited loss. It is also possible in a market where prices are chang-ing rapidly that an option writer may have no ability to control the extent of his losses. Option writers should be sure to read and thoroughly understand the Risk Disclosure Statement that is provided to them. |