The What and Why of Options

by Keith Schap  ISSUE 208 | SEPT 2003

Options on futures can be an incredibly flexible trading tool, and they are not as difficult to understand as some people make them seem. True, options make use of some special terminology and depend on some factors that need not concern futures traders. At the same time, options are options. What you know about stock index options translates readily to options on Treasury futures or on soybean futures. So options are well worth learning about.

The What

When you buy a call, you have the right, but not the obligation to buy the underlying futures contract for a specified price — the strike price.

When you buy a put, you have the right, but not the obligation, to sell the underlying futures contract for a specified price — the strike price.

In either case — call or put — you pay a price for this right. This is the option premium. For option buyers, this cost defines the maximum possible loss. For option sellers, it defines the maximum possible gain.

This may seem abstract, but it describes situations we deal with all the time in our everyday lives. Everyone who has a mortgage has bought a call option. Every mortgage holder has the right, but not the obligation, to refinance at a lower interest rate. If interest rates rise, the holder has no obligation to do anything other than continue with the existing mortgage.

Suppose you buy replacement value insurance coverage on your new car, and a truck totals your car on a mall parking lot the day after the coverage goes into effect. Your insurance policy gives you the right to sell your car to the insurance company for full value. Of course, if nothing happens to your car during the term of the policy, you don’t have to do anything. That is, when you buy an insurance policy, you are buying a put option.

To apply this to the markets in options on futures, suppose December CBOT DJIA futures are trading at 9280, and you buy a 9400 December call. Consider only two of the possible outcomes.

First, a week later, the futures are trading at 9250. This call gives you the right to buy the futures at 9400. This makes no economic sense when you can buy them at a lower price in the futures market. So, in the absence of obligation, you can ignore the option.

Second, another week later, the futures are trading at 9500. This option gives you the right to buy futures at 9400. Theoretically, you can turn right around and sell the futures at 9500. Given that, you might consider exercising your right to buy futures at this price.

These examples hint at two of the three ways you can exit an option position. First, you can ignore the option and let it expire valueless. Second, you can exercise your right to buy (if you bought a call in the first place) or sell (if you bought a put) futures. The third alternative is to offset your option position any time before option expiration. If you bought the 9400 December call, you offset by selling a 9400 December call. If you bought a 9000 December put, you offset that by selling a 9000 December put.

Offset is by far the best way to exit option positions no matter where the futures price is relative to the option strike price. Indeed, it is possible to demonstrate that exercise is never economically optimal.

The Why

You might wonder why you should go to all the trouble of learning about options when you can more easily buy or sell futures. Two reasons come to mind: leverage and risk control. Examples can again make the ideas clear.

Suppose that December CBOT DJIA futures are trading at 9280 and you are bullish the stock market. To express this opinion, you can:

• buy December CBOT DJIA futures @9280
• buy a 9300 December call on these futures @37.95

Both actions allow you to control a similar exposure to the stock market—the futures position has a $92,800 value (9280 x $10 futures multiplier) while the option controls a position with a $93,000 value (9300 x $10) — but there the similarities end. (Note: you can also trade CBOT mini-sized Dow futures, but, with its $5 multiplier, it would take two of these contracts to have the same stock market exposure.)

For one, when you trade futures, you must post margin. At the beginning of September, the initial margin for CBOT DJIA futures was $5,400. The maintenance margin was $4,000. When you buy an option on DJIA futures, you must pay the premium in full — in this example $3,795 (37.95 x $100). You can see that the initial cost of the option right is less than that of a futures position.

For another, the risk-reward profiles look very different. Table 1 shows the gains or losses for the long futures and 9300 call positions after two weeks have passed. (Options prices do not move one for one with the futures price. The consequences of this can be extremely interesting for option traders, but this is a topic for another time.)

Table 1: Futures and Call Option Outcomes
Initial Futures Price	Ending Futures Price	Futures Result (long at 9280)	Call Option Result (9300 call)
9280	9900	$6,200	$3,700
9280	8700	-$5,800	-$2,475
9280	8400	-$8,800	-$3,110
9280	7500	-$17,800	-$3,750

With futures, you can plainly see, the losses pile up as long as the market drops. Obviously, a 7500 Dow would be catastrophic, as the $17,800 futures loss illustrates. As bad as that would be for a long futures position, a call buyer would suffer only a $3,750 loss (given the market data behind these examples).

This example shows that futures have a symmetrical risk-reward profile. Chart 1 illustrates.

The Symmetry of Gain and Loss in a Futures Position

 

In contrast, options have asymmetrical risk-reward profiles. Chart 2 shows in graphic form what Chart 1 shows in numerical form — that a call cuts off the loss side but leaves the gain side open.

The Asymmetry of Gain and Loss in a Long Call Position

 

Keith Schap is a Senior Writer in Business Development at the Chicago Board of Trade.

Laura Oatney is editor of LindForum. She can be reached at editor@Lind-Waldock.com.

“Dow Jones,” “The Dow®,”“Dow Jones Industrial Average,” “DJIA” are service marks of Dow Jones & Company, Inc. and have been licensed for use for certain purposes by the Board of Trade of the City of Chicago, Inc. (CBOT®). The CBOT futures and futures options contracts based on the Dow Jones Averages are not sponsored, endorsed, sold, or promoted by Dow Jones, and Dow Jones makes no representation regarding the advisability of trading in such contracts.

The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations.

© 2003 Lind-Waldock, A Division of Man Financial Inc. All Rights Reserved. Futures Trading Involves Risk of Loss.