- Jan 13, 2010
A Brief Introduction to Commodity Options
The theory and practice of option trading is diverse and in some cases complicated. Accordingly, it is impossible to do the topic justice in such a brief mention. The purpose of this section is to merely introduce the subject.
Options can be purchased outright, in conjunction with futures contracts or even as a package in which both short and long options of various types are used. There are no limits to the versatility of option trading. Commodity options provide a flexible and effective way to trade in the futures markets with various amounts of potential risk and reward. For example, through the combination of long and short calls and puts, investors can design a strategy that fits their needs and expectations; such an arrangement is referred to as an option spread.
The method and strategy should be determined by personality, risk capital, time horizon, market sentiment, and risk aversion. Plainly, if you aren't an aggressive individual with a high tolerance for pain, you probably shouldn't be employing a trading strategy that involves elevated risks. Doing so often results in panic liquidation of trades at inopportune times and other unsound emotional decisions.
What Is an Option?
Before it is possible to understand how options can be used, it is important to know what they are and how they work. 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 types of options, a call option and a put option.
- 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 the option being exercised.
- 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 if the buyer chooses to exercise the option. Keep in mind that delivering a short futures contract simply means being long from the strike price.
Similar to futures contracts, there are two sides to every option trade; a buyer and a seller. Option buyers are paying for the underlying right, whereas sellers are selling that right. The most important thing to remember is that option buyers are exposed to risk limited to the amount of premium paid, whereas option sellers face theoretically unlimited risk. Conversely, option buyers have the possibility of potentially unlimited gains, whereas the profit potential for sellers is limited to the amount of premium collected.
Table 1.1. Call buyers are Bullish, but put buyers are Bearish; the opposite is true of call and put sellers.
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.
The majority of beginning option traders prefer trading outright options (buying or selling calls or puts) due to their simplicity. However, there are definite advantages to becoming familiar with the flexibility of risk and reward when using option spreads.
- The term "spread" typically implies hedge. In theory, one or some of the components of the spread will hedge the risk of others.
An option spread is the combination of two different option types or strike prices to attain a common goal. The term option spread can be used to refer to an unlimited number of possibilities. For example, an option spread can involve the purchase of both a call and a put with the same strike prices, or it can be the purchase and sale of two calls with different strike prices. The sheer number of possibilities makes this topic beyond the scope of this book, but if you are interested in learning more on option spreads, you might want to pick up a copy of Commodity Options that I authored and was published by FT Press.
To add to the confusion surrounding commodity vocabulary, an option spread has its own bid/ask spread. Just as a single call or put would have a price that you can buy it for and a price you can sell it for, a spread is priced as a package and will have both a bid and an ask that represents the purchase or sales price for the combination of options.
Fortunately, when dealing with a spread on a spread, most insiders identify the bid/ask spread by its full name while referring to the option spread by its specific name as well. For example, if a broker calls the trading floor to get a quote for an option spread, she might say something like this to the clerk that answers the phone, "Will you get me the bid/ask on the 900/950 call spread?"
It is important to realize that when getting a quote for an option spread from a broker, it isn't necessary to decipher whether you will be buying or selling the spread. This is because the broker will give you the quote for doing each. Thus, the bid/ask spread.
Once again, option spreads are too complex to discuss in any detail within this text. However, you need to realize that when it comes to option spreads, if it costs more for the long option of the spread than it does for any short options, the trader is buying the spread. If it is possible to collect more premium for the short legs than is paid for the long legs, the trader is selling the spread.
In conclusion, traders are doing themselves a disservice by ignoring the potential benefits of incorporating option trading into speculation. Although option trading can seem complex on the surface, you owe it to yourself to be familiar with all the tools available to you as a trader. After all, I think we all agree that taking the "easy road" in life often fails to be beneficial in the end, and this may be no different.