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By Kevin Warner and CFEA

This article will be an ongoing educational feature included weekly with the Commodity Talk Paper Trades. The purpose of this article is to educate readers on options, and show them how to incorporate option trading into their own trading.

Options on futures were introduced in 1982 when the Chicago Board of Trade began trading options on treasury bond futures as part of a government pilot program. The success of the program led the way for options on agricultural products, metals, and other financial futures. However, despite the fairly recent advent of options on futures, the options market is not new.

Options have been used with physical commodities, securities (stocks and bonds), and real estate for decades. There was over-the-counter trading in stock options long before the creation of the Chicago Board Options Exchange (CBOE) in the mid 1970’s, to trade stock options. Over the course of the next several months we will be presenting readers of The Amazing Paper Trades with a comprehensive look at options, and how to use them in your trading.

But, before we get down to brass tacks, we need cover a few definitions. Sorry, this is boring but we need to cover the basics before we move on.

There are two basic types of options:

• A Call Option gives the buyer the right, but not the obligation, to purchase a particular futures contract at a specific price anytime during the life of the option. In exchange the purchaser of a Call Option pays the premium for these rights to the seller (writer). The seller of the Call Option has the obligation to deliver the particular futures contract, and in exchange for granting these rights, the writer gets the premium.
   
• A Put Option gives the buyer the right, but not the obligation, to sell a particular futures contract at a specific price anytime during the life of the option. The purchaser of the Put Option pays a premium to the seller of the option for these rights. The seller of the Put Option has the obligation to accept delivery of a particular futures contract at the strike price, and in exchange for granting these rights, the seller of the Put collects the premium from the sale of the option.

Just as futures contracts are standardized, so are options contracts on futures. Each option has predetermined strike prices and expiration dates. Each options contract can only be offset before expiration by either selling a like option (same commodity, month, and strike price call or put) or by exercising it into a futures contract at the strike price. Call options are exercised into a long futures position at the strike price by the buyer, and Put options are exercised into a short futures at the strike price by the buyer of the put option.

The price at which the buyer of a call option has the right to purchase the futures contract or the buyer of put option has the right to sell the futures contract is known as the strike price (or exercise price). The amount of time the purchaser of the option has the right to purchase (call options) or sell (put options) the underlying futures contract is known as the expiration month. The only variable in the equation is the price paid for this right, known as premium, just as the only variable in a futures contract is the price at which it is traded.

Prices are compliments of barcharts.com

The purchaser of an option – one who is either long a Call or a Put option – has risk limited to the amount he/she paid for the option. At no point can the option buyer lose more than the premium paid for the option.

The option seller – known as the writer, who is either short a Call or a Put option – has unlimited risk and the reward potential is limited to the premium collected.

Now that we have a basic understanding of what options are, we can begin to look at using options in your trading. Though at first glance, buying options may seem like a no loose proposition, nothing further from the truth could be true, as options are a decaying asset meaning they loose value each day as expiration approaches, hence making market timing even more critical than with futures contracts. This disadvantage to the option buyer is an advantage to the option seller, as most options written expire worthless – allowing the option writer to collect the premium.

Next week we will discuss the merits of buying options versus selling options, presenting traders with look at the advantages and disadvantages of these basic strategies and how the market place asses the “odds” that the option will expire beyond the strike price or not.