Options Tutorial

THE BASICS

Purchasing a call option gives the buyer of the option the right, but not the obligation to be long the underlying futures contract at or above the strike price of that particular option. For example, let us say August Gold is at 400.00, and you believe the market is getting ready to break out and go higher. One choice would be to buy an August 410 (410 being the strike price) Gold call option. For our purposes here, let's assume a premium (cost) of 800.00. If the Gold futures market were to move up to 430.00, you would have 2000.00 in intrinsic (in-the-money) value. For every dollar the Gold futures moves up, the option will increase 100.00 in intrinsic value. The ACTUAL value of the option could be higher, depending on time value, and the volatility of the underlying market.

Purchasing a put option gives the buyer the right, but not the obligation to sell (be short) the underlying futures contract at or below the strike price of that particular option. Using the above example, we once again see the August Gold trading at 400.00, and you think the market is poised to break to the downside. The decision is made to purchase an August 390 (390 being the strike price) Gold put option for a premium (cost) of 800.00. If the Gold futures market were to tumble to 370.00, there would be 2000.00 of intrinsic value in that option, with the ACTUAL value possibly much higher, once again depending on time value and volatility.

STRIKE PRICES

The closer the strike to the current futures price, the higher the premium (premium = the cost of the option)

The closer to the money options will increase in value faster than the farther out strike prices. This rate of change (futures vs.options) is known as the "delta". Without getting too complicated, the typical "delta" of an "at-the -money" option is about .50, meaning that a 10 dollar move in the futures will represent a 5 dollar move in the option. The delta will increase as the option gets deeper in the money.

Depending on the traders outlook, one would USUALLY purchase as close to the money as possible, normally 1 to 3 strike prices out.

TIME VALUE and EXPIRATION

Simply put, Time is money. The farther out in time you go, the more expensive (higher premium) the option will be.

If possible, try to purchase options that will have at least 25 to 30 days of time value left (more days are better) beyond the expected termination of the trend. The reason for this is that the time decay accelerates dramatically in the last 30 to 40 days of an options life. If you need more time, often one should consider liquidating with about 30 days to go, and reposition in a farther out (in time) option.

The farther out-of-the-money options will have time decay at a faster rate than the closer to the money options.

VOLATILITY

The main guideline here, is to TRY to buy options in times of relative quiet in the market, naturally hoping for MORE volatility after you purchase the option. The higher the volatility, the higher the premium will be, sometimes making options overvalued (translated=you pay too much!)

TIDBITS

"The worst thing that can happen, is I lose all my money" is a refrain often heard in the option world. Heck, I have said it myself, and I sure ought to know better!! That thought process is too high a price for not having to worry about a margin call in the futures market. If the market is not going your way, try your very best to liquidate the option when it has lost 50 to 60 percent of it's original value. Not following this general idea is the reason 80% (or more) of all options expire worthless. Read below regarding placing stops on options.

Most all options markets are far less liquid than the futures markets. This can lead to distortions in price, as well as "slippage" in market orders. Always try to place a price order, but sometimes market orders are un-avoidable.

There are more variables in option trading, as opposed to futures. While the fact is that the limited risk of options will always be an attraction, BE CAREFUL!! Every option trade is essentially a 3 step process. One must be correct in recognizing the pattern or market direction, as well as overcoming time and volatility premiums. This is not meant to scare or discourage you, but not being aware of these things could hurt you in the long run.

PLACING STOPS ON OPTIONS

One of my credos in futures trading is- NEVER enter a trade without a protective stop-loss. The lack of liquidity in most option markets make placing a stop loss order difficult at best. My over all recommendation is to monitor the market regularly, and simply exit your position when the option is at or about half the value you paid for it, OR if the underlying (futures) market negates your original outlook.

NAKED WRITES (or selling uncovered options)

This strategy is essentially NOT for novice or smaller traders, even though a high % of options expire worthless. A common thought is to sell (write) options beyond the trading range of the last 3 to 6 months, hoping to see them expire worthless. This strategy can work regularly, but when you are wrong, you are REALLY wrong, and the unlimited risk exposure makes it VERY dangerous. Added to this, there are the usual margin requirements needed, so often times the return on equity can be quite low. Although most professional option traders are option sellers, they are usually hedged one way or the other, and the ones that aren't can implode at any time. Horror stories abound!!

AN IDEAL OPTION TRADE

This is a dream scenario First of all, there will be a pattern which you like, while the market is experiencing relatively low volatility, which in turn helps you pay as little as possible for time value. Hopefully, one can purchase an option set to expire 25 to 35 days beyond the expected termination of the trend. Usually, the wisest course of action is to purchase options 1 to 3 strike prices out of the money, but this choice would be dictated by your analysis as to the strength and duration of the trend.

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