Let me put a disclaimer out here from the start: Any attempt to have call options explained is not easy, and it normally takes a while (it took me at least a week) to fully grasp the concept of what a call option is, and what it represents. Options are an ever-evolving concept for me, and I’m pretty sure any active options trader will tell you the same thing. There are many different types of options out there, and each one would require its own website worth of information to grasp each individual concept. In addition, there’s a whole mathematical side of options trading that completely confuses the heck out of me (like how the Black and Scholes model works), and I don’t claim to understand the extremely complicated equations that explain option decay, option price movement, and so forth. I’m much more of a simple kind of guy, so I was always very appreciative whenever I found any kind of information on the Web that explained options in “layman’s terms”, so to speak. So I’m not going to delve into any deep theories about options pricing models or anything like that; I’m simply going to explain what a call option is from a very top-level, 30,000-foot-view type of perspective.
I have traded both commodity (or futures) and stock options, but for ease of explanation, I’ll just narrow it down to futures options. An option, whether it’s a call option or a put option, is a contract that basically gives you the right, but not the obligation, to buy one futures contract for a fixed price within a fixed time period. That already sounds a little convoluted…see, I told you that it may take a few days to sink in. Think about it this way…if you were at a department store and you wanted to buy a DVD player that was on sale, but then you found out that the last one was sold before you had a chance to get to it, most stores will allow you to create a raincheck for that item. Meaning, once they get the DVD player back in stock, even if it’s way after the sale is over, you still have the right to buy the DVD player at its sale price, because you basically “staked your claim” while the item was on sale. Now you’re not obligated to buy the DVD player even though you have a right to buy it; this is the same principle at work with call options. For example, if you bought a call option on Corn, you would now have the right (but not the obligation) to buy one Corn contract at a price that you choose (otherwise known as the “strike price”).
The whole point of buying call options is that you expect the price to rise in the relatively near future. So if Corn is trading at 460.00 (which it happens to be right now), you might want to buy a call option with a strike price of 460.00, and if the price of Corn does indeed rise, you are now making a profit on your call option. Somebody might ask “Well, if that’s the case, why not buy the Corn futures contract outright instead of just buying a call option?” There’s a big difference in price between one Corn futures contract and a call option representing one Corn futures contract. If you bought the contract outright, you’re looking at an initial margin outlay of roughly $2,000 (but it does fluctuate), but if you bought an option on that same Corn contract (and by the way, every option contract represents 1 futures contract), you would only be laying out a fraction of that price. For instance, as of this writing, with Corn trading at about 460.00, a call option with a 460.00 strike price (closest expiration month) is going for about $840.00 right now. Another HUGE benefit of buying call options is the fact that (unlike buying the futures contract) your risk is limited; with buying options, you can never lose more than your initial investment. If you were to buy a Corn contract outright and the market wildly moved against you (which happens more often than we are comfortable admitting), you could not only lose all of the money in your account, but be liable for whatever deficit is owed on the contract as well–this is known as a “margin call”, and if you’ve ever received one, they are no fun…I know this from experience.
So with our Corn call option example (460.00 strike price), $840.00 is the most you can lose, so you know your total risk level right off the bat. Once you buy the option, your risk is set, and you now have the right to buy one Corn contract stock at the 460.00 price level, no matter how high the actual futures price goes. If Corn were to have a major spike in price and shot up to 500.00, you still have the right to buy your Corn contract at 460.00. So, in this example, you would do what’s known as “exercising your option”, giving you the right to enter into a position where you purchase 1 Corn futures contract at 460.00, even though the market is currently trading at 500.00, meaning you have a 40 cent (remember, Corn’s futures price is denominated in cents per bushel) profit right off the bat. Multiply that times the point value of each cent, which would be $50, and you now are sitting nice and pretty with a $2,000 profit (40 cents x $50)! It’s a great way to manage the volatility of futures prices without seeing your trading account fluctuate up and down with the price movements, plus it greatly reduces your overall capital at risk.
Some people will do what’s known as buying “out-of-the-money” call options, meaning call options with strike prices that are well above the current market price. For example, if you were to buy a call option on Corn with a strike price of 490.00, even though Corn is currently trading at 460.00, it would be much less expensive, because “out-of-the-money” option prices (also known as “premiums”) are based on the probability of whether or not the futures contract will ever actually hit that price. So, buying a Corn call option with a 490.00 strike price (when Corn is currently trading at 460.00) will only be about $350.00–very cheap indeed. But if Corn were to have a dramatic and quick spike in price, and it jumped up to 500.00, your call option is now “in-the-money”, because Corn’s price is higher than your strike price, and you would be sitting with a pretty nice profit on your option. You don’t even have to exercise your option to make a profit on it; the options themselves will increase in value along with the futures contract’s increase in value. There are many cases where people have bought options for no more than $25.00 or $50.00, and they ended up being worth hundreds of dollars or more when dramatic price movements in the underlying futures contract happened.
Whoa, I just checked my word count on this post, and it’s ridiculous. I’m realizing even as I write this that there’s really not a “simple” way to explain options. Nonetheless, I hope this little diddy on call options explained has at least begun to bring some clarity to this detailed area of investing.
It’s amazing how many people who are just entering into the realm of commodity options trading don’t seem to keep in mind the basic factor that makes options do what they do, and that’s volatility. If you understand the effect that volatility has on the options market, you will understand how sometimes extraordinary profits can be pulled from trading commodity options with very little relative investment. When you trade options, you are basically trading volatility, nothing more, nothing less. There’s no such thing as a “stable” option. Remember the option is only going to be as stable as the futures contract that the option represents. If there’s a whirlwind of speculation going on in the futures contracts (a la crude oil), you can guarantee automatically that option writers are padding their premiums to compensate for any potential moves that the market might make against them. Simply put, volatility is the measure of “nervousness” that’s in the markets, based on a sense of uncertainty as far as what the futures prices might do, or where those prices might go. Volatility is basically reflected in the sharp rises and drops in option premiums, and the degree of fluctuation that those premiums experience. If you use it right, volatility can be your best friend. Once you understand a little about market psychology, you can truly exploit volatility to create some serious profits in a relatively short period of time. That’s one thing that I emphasize to people when I talk about commodity option trading, is the fact that you have to be ready to “strike while the iron is hot”. Unfortunately, options trading is not something you can do as a “set and forget” type of investment; it requires your active involvement. Reason being is because there are opportunities that crop up in the options markets all the time, but if you hesitate, or fail to recognize the opportunity when it’s staring you in the face, you will definitely miss out on the whole enchilada.
Before I get sidetracked, let me mention the fact that there are two types of volatility in commodity options trading (and really all options trading for that matter): Historical and implied. Historical volatility is basically the “track record” of a given futures market’s price swings. In other words, how stable (or unstable) have market prices been throughout history? There are all kinds of charting tools to measure historical volatility, and it’s good to study them to get a “feel” for how a market’s prices will have regular peaks and valleys, especially more seasonal-based commodities like the grains (corn, wheat, soybeans, etc.) and for the most part the softs (coffee, sugar, cocoa, etc.). Implied volatility is the kicker-it’s basically the market’s guess at how stable (or unstable) prices will be in the future. The basic reason why it is important to understand volatility is because it will tell you what your best plan of action is, as far as what type of position to take in the markets. If you expect volatility to increase, it’s NOT a good idea to write options. Conversely, if you expect volatility to decrease, buying options will prove to be a disappointment, because time decay will “do its dirty work” on the option’s premium, and you’ll see your profits (if any) eroding away right with it. So, to put it in a positive light, if you believe that volatility will increase, it’s better to buy options, and if you believe that volatility will decrease, it’s better to sell (or write) options.
Well, I have to sign off for now; I’m actually about 20,000 feet in the air, making my descent into Atlanta. I just thought that I would take the time to post some more thoughts about commodity options trading while I was in flight…it’s amazing how (and when) inspiration will hit.
In the realm of commodity options trading, you have to be prepared to face the uncertainties and volatility that the futures markets can throw at you. Make no mistake about it, when you enter into the arena of futures options trading, you are truly throwing down the gauntlet for the “ultimate challenge”. You have to keep in mind that options is simply a game of educated guesses. It’s always based more on what everyone thinks the market is going to do, instead of what it is actually doing. It is vital for you to make that distinction before even beginning to enter a trade. The options markets are inherently speculative. The whole drama of it is the big question mark about what the markets may or may not do. This is where you get volatility skews and parity in puts and calls. This is why option writers pad their premiums the farther out in months the options go, because they realize that the farther the timeline extends, the more probability there is for uncontrollable events to affect market prices. It has always been the sign of “options noobs” to buy cheap out-of-the-money calls that have a large amount of time left, only to see their option values decay as time passes, while the market simply doesn’t “shake up” enough to affect premiums to their advantage in any way. A lot of people fall victim to the misconception that 80% of options expire worthless, and while that sure seems like it’s true, it’s not–80% of options are never exercised, mostly because they are later offset. The reason why I mentioned this here is because if you plan on buying a cheap out-of-the-money call with a ton of time left, be prepared to see a dramatic drop in the value of your option as time passes, unless the underlying market does some major moving & shaking during your “holding period”. When this major drop in value happens, if you are wise, you will exit by offsetting your position instead of allowing your option to expire worthless. This is an integral part of money management, which is probably the number one requirement for a person to successfully engage in commodity options trading; you have to conserve your trading capital and not try to be some super-hero, willing to hock your house on a lucky chance. Know when you’ve been beat…I repeat, you gotta know when you’re getting your butt kicked in the markets, and exit gracefully, even if you take a hit in your trading capital. It’s better to be prudent than to struggle with trying to “be right” and “teach the markets a thing or two”…the only thing that will happen is that they’ll teach YOU a thing or two, and have you pay tuition for the lessons.
So it becomes very important in futures options trading to pay attention to what’s going on with the underlying futures contract, because the option’s movements are always going to be based on this, no matter how strange they may behave sometimes. And again, always keep in mind that option writers are not dummies; they’re like insurance underwriters…they’ve done their homework, they know the percentages and probabilities of profits or losses for each strike price, and for the most part, they adjust their premium prices accordingly. Occasionally, they will get blown out by sudden market spikes or sell-offs, but at the end of the day, it is an art to recognize a truly undervalued option, and then be able to properly capitalize on trading it. In this blog we will go into various commodity options trading strategies, and learn how to recognize these opportunities in the markets when they present themselves. I can’t promise some majorly structured lessons, like a curriculum or anything, but I will share some of my successful trades (and some of my duds), and you can hopefully see these trades in action. One thing is for sure; with every trade, no matter if you come out with a profit or exit with a loss, you learn something. You pick something up. You have another tidbit of information to add to your trading repertoire, and you’ll always be better prepared for the next trade than you were for the last one. This, my friend, is some of what it takes to cut the mustard in trading commodity options.
Here I’ve written some thoughts on commodity option trading, and what it means to me…I want to develop in the art of being a good trader; this means more than just making a bunch of money. I want to truly develop discipline and skill as a trader, and to constantly challenge myself to become a better trader. I believe that making a ton of money will naturally follow when you develop into being a good trader. Good trader=root; Tons of $$$=Fruit. I truly believe in the ”base hits” theory; enough base hits will eventually equal the home run. In other words, steady, consistent profit-taking when trading commodity options is more in line with sound trading principles (in my mind) than waiting on (and betting on) a “home run”. This helps me to avoid falling into the “jackpot mentality”, where you’re trying to play the markets like you would play the lottery. Any time a person approaches commodity options trading with a gambling, “fast-buck” mentality, they’ll see profits running in the opposite direction. Those who attempt to make a killing in the markets end up getting killed. I fully believe in being aware of (and respectful of) the power of leverage at all times. Leverage truly is a two-edged sword. You must treat it with respect, and never be presumptuous or arrogant about the markets, as if you can always predict their movements. I believe in maintaining the attitude of flexiblility, where even my most informed decisions about how I’m going to enter or exit a trade, could be wrong based on the market’s movements. I believe in using the widsom that God gave me to keep me from making a trading decision that would be thoroughly disatrous. I don’t think there’s any shame in (or even anything wrong with) taking a loss. I believe that taking a loss in trading commodity options can actually be part of a winning strategy. It’s stupid to commit to a trading idea once you realize you’re going the wrong direction. It’s like the guy who gets “pot committed” in poker; it’s hard for him to walk away because he has put so much money in already…so he continues betting (and bluffing) until the entire fantasy comes crashing down on him, when the final hand is played. No need to do any of that drama; you just have to be smart in commodity option trading, and know your risk levels, as well as know when to say “uncle” and throw in the towel. Live to trade commodity options another day.keep looking »