What are Options on Futures?

By Lind-Waldock

June, 2005

An option is an instrument that in simple terms, is based on an underlying futures contract. Options trade on regulated exchanges side by side with the underlying futures, and their value is calculated using variables similar to other types of options you might be familiar with. So if you understand equity options, you are ahead of the game. When a futures option is exercised, you will have a futures position based on that option's strike price. Any futures contract can have options on it, although not all do.

The cost of futures options is called premium, and it's based on time, volatility and the relative value of the strike price in relation to the underlying market.

An options investor not only cares where a market is going to go, but how quickly it's going to get there. Options prices depend on volatility of the underlying market. If a volatile market rallies, but within small ranges, an option buyer who picked the market direction correctly might still lose money. That's because options are priced lower in calmer markets and higher in more volatile ones.

Options lose value over time. Every week that goes by means the option loses more time value. Every week the market fails to move in the direction you are anticipating is another week the option can lose some of its value.

Types of Options
There are two types of options, puts and calls, and for every transaction, there is a buyer and a seller. The buyer of calls or puts is the one who gains the right, but not the obligation, to be long or short once their strike price is reached. The seller of calls or puts is assigned the obligation to fulfill those rights. Offsetting a position is the most common way of removing the obligation or the right. The call buyer anticipates a market rally, and the put buyer is looking for a pullback.

Call Option
The call buyer has the right (but not obligation) to purchase the underlying futures contract at a specified price (the strike price) on or before the expiration date.

Put Option
The buyer has the right (but not obligation) to sell the underlying futures contract at a specified price (the strike price) on or before the expiration date.

The option buyer pays money, while the seller receives it. The most a buyer can lose is the premium paid for the option, while the most the seller can make is the premium they receive. The option can increase in value in an unlimited amount, so the buyer has unlimited potential. On the other hand, the seller faces unlimited loss.

However, one position isn't more risky than the other, only different. While the seller may face potentially unlimited losses, time decay actually works in favor of the seller. In theory, the market prices the options to be indifferent to either buyers or sellers.

Determining the Value of an Option

Different options will have different values. An option's price is determined by three factors: the underlying market, volatility and time remaining on the option to expiration.

The price of the underlying futures contract is the main factor in the option's price. As prices rally, you'd be willing to pay more for the right to buy call options. So, forecasting rallies and breaks in futures is the primary focus of options investing.

For a call, a strike price above the underlying futures is considered "out of the money," while a price below the underlying futures is "in the money," and a price equal to the underlying is "at the money." For puts, it's the opposite. Here is an example to show you more clearly this concept.

If a futures contract is trading at $400:

Call Strike Price	Put Strike Price
$350 in the money	$350 out of the money
$400 at the money	$400 at the money
$450 out of the money	$450 in the money

Volatility is another factor that determines the price of the option. An option in a volatile market is worth more than one in a calm market. So, a market with quick swings and spikes increases the value of both calls and puts, while decreasing volatility lowers their value. Look at it as demanding greater compensation for the more valuable option - the option has a greater chance of moving in your favor in a more volatile market.

Buyers of options are said to be long volatility, while sellers are short volatility. You can determine volatility in various ways. You can track implied volatility as well as historic volatility; look at the current volatility with past time periods to determine if it's high or low in comparison.

The amount of time remaining until expiration also plays a part in options pricing. More time remaining to expiration is more valuable than less time to expiration. An option with two days remaining until expiration will have less time, and therefore less probability of making a move in your favor. At any given time, the market is pricing in the probability the underlying market will move. So, with every week that passes, the time premium of the option is lessened.

Non-linear time decay means the time decay erodes more quickly in the final days and weeks near expiration. Time decay is steepest for at-the-money options because they have the greatest time value, and therefore the most to lose each week.

Price, volatility and time value are the most important factors affecting the price of options, but there are other elements that affect options values.

Interest rates in the economy impact the value of the option. Because options are highly leveraged, they tie up only a portion of the money you'd otherwise invest in the underlying futures contracts. But ultimately, it's the marketplace that determines the price of the option, or supply and demand.

Common Options Myths

Myth: If the underlying market goes my way, the option will gain in value. That is, in rising markets, the call will increase in value. Well, that's not always the case. Choosing market direction is important, but equally important are issues of time value and volatility.

Myth: Buying options has limited risk and therefore is safer than selling options. It is true buying options does have limited risk, but it's still substantial, and you still risk losing 100 percent of the cost of the option. It's better to say by buying options, you define your risk. The outcome of any given trade is unknowable and risky.

Myth: Options are complicated and difficult to understand. Of course there are advanced trading strategies, but options trading doesn't have to be complicated.

Myth: Successful options trading requires fancy computers to evaluate opportunities. You can get by tracking options price and the underlying futures price, because there is still a human part of the equation that's key. Every strategy relies ultimately on the correct forecast of the market by the investor.

Myth: Buying underpriced options and selling overpriced ones provides a valuable edge in trading options. The market prices options for a reason, so if prices diverge from their theoretical value, that's valuable information to know. But it doesn't mean you should automatically be buying or selling.

Myth: Buying options is a good way to protect against risks in existing futures positions. Investing is a risky business. You may have heard options protect against risks, but it doesn't completely hedge you. It may outweigh losses on a futures position, however, at times.

If you'd like more information about options in general, or specific strategies using options, please feel free to call Lind Plus at 800-571-1122 to speak with a Market Strategist or email lindplus@lind-waldock.com.

Dwayne Pliska is a Senior Market Strategist with Lind Plus. He can be reached at 800-574-4189 or via email at dpliska@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, and any dollar amount quoted is exclusive of commissions and fees. All trading decisions will be made by the account holder.

© 2005 Lind-Waldock, A Division of Man Financial Inc. All Rights Reserved.