The ABCs of Options

By Paul Nowak   ISSUE 609 | SEPT 2007

Most people are intimidated by options, but they're not as complicated as you may think. Options are among the most versatile financial instruments out there and can help you significantly limit your risk or provide extra income. Understanding them is crucial to the success of a trader as they provide another tool that can fit well with your overall trading strategy.

What are Options?

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a specific price on or before a given date. A call gives the option holder the right to buy, while a put gives the option holder the right to sell. The price at which the option is executed is known as the strike price.

The options holder refers to someone who buys options. Option writers are those that sell options. Option holder (buyer) has the right, but not the obligation, to buy or sell, while the option writer (seller) is obligated to buy or sell.

In addition to there being two basic types of options (calls and puts), there are also different styles of options depending on the product being traded, with different expiration procedures. American-style options can be exercised at any time prior to expiration. European-style options can only be exercised at the expiration of the option contract. Both types trade on U.S. exchanges.

Why Trade Options on Futures?

• Defined Risk: Your risk is limited to the option premium paid when buying an option. Risk is unlimited when writing an option.
  
  
• Risk Management: Options can help you protect your positions against price fluctuations when you don't want to alter your position in the underlying.
  
  
• Trading Opportunities: A wide variety of strategies can be created using options from conservative positions to risky ones.
  
  

Basic Terminology

Premium – The cost of the option contract itself.

Strike Price – The price at which you can take a position in the underlying contract.

Underlying – The futures contract that the option is based on (i.e., March crude oil futures, December corn futures, June S&P futures, etc).

Exercise – The act of exchanging the option for a position in the underlying futures. contract. The holder of an option exercises the right to buy (in the case of calls) or sell (in the case of puts) the underlying future at the strike price.

At-the-Money – If an option is at-the-money, the option's strike price is the same as the underlying price. For example, if March crude futures are trading at $71, the March crude 71 puts and March crude 71 calls are both at-the-money.

Out-of-the-Money – If the option is out-of-the-money, the option's strike price is higher (for calls) or lower (for puts) than the underlying price. For example, if March crude futures are trading at $71, the March crude 75 calls and 68 puts are both out-of-the money.

In-the-Money – If the option is in-the-money, the strike price is lower (for calls) or higher (for puts) than the underlying price. For example, if March crude is trading at $71, the March crude 70 puts and 78 calls are both in-the-money. In-the-money options have intrinsic value, because they could be exercised and the resulting futures position immediately offset in the futures market for profit.

For more terms, visit our Options Dictionary.

How are Options Valued?

So what determines an option's value? In general, the option's price is determined by the perceived probability of it expiring in-the-money. Of course, the basic fundamental forces of supply and demand still hold. Ultimately, the contract is worth whatever someone will pay for it.

There are three major factors that determine the option's price (premium): the underlying market, volatility and time remaining to expiration.

• Underlying: The main factor determining the option's price is the price of the underlying futures contract. The price of the underlying determines if the option is in-the-money or out-of-the-money. For example, if the price of the underlying market rallies, investors likely will pay more for the right to buy call options.
  
  
• Time: The more time there is until expiration, the greater the chance that the option could finish in-the-money. Therefore, the price of the option will be higher. The passage of time works against the option buyer because out-of-the-money options decrease in value at an accelerating rate as the expiration date approaches. This is commonly known as time-decay.
  
  
• Volatility: The price of an option is also determined by volatility. As market participants anticipate large price swings, the chances of an option finishing in-the-money theoretically goes up, as will its value. An option in a volatile market is worth more than one in a calm market. Buyers of options are said to be long volatility, while sellers are short volatility.
  
  

This article introduces some of the basics of options. If you'd like to learn more, join Lind-Waldock and CME Group Inc. on Wednesday afternoons at 3:30 C.T. October 24, 31, and November 7, 2007. We're hosting a special online event series focusing on options titled, Futures Options Forum: Advanced Strategy Sessions for Traders. You can join a panel of leading industry professionals live online who will discuss more sophisticated options topics. Click here to learn more and sign up to attend this free event. You can also read more about this special series in the feature in this issue of Lind eWire.

Paul Nowak is Events Manager at Lind-Waldock. He can be reached at 312-788-2855 or via email at pnowak@lind-waldock.com.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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