Chapter 4
Some Basic Concepts About Options on Futures
In This Chapter
Getting the lowdown on types of options and traders
Speaking option-ese (both English and Greek)
Factoring in volatility
Checking out other resources
Why would a book on trading futures have a chapter on options? The answer is actually fairly simple. Options on futures are quite an important part of the market, and it’s important for you to be exposed to the very basics of the options market as they relate to futures. This chapter is by no means a complete treatise, but rather a broad overview of the major aspects of options on futures. You can get a whole lot more by reading Trading Options for Dummies by George Fontanills (Wiley).
Still, trading options, even options on futures, doesn’t have to be confusing if you take the time to discover the specific nuances of the market. In fact, when used properly, options give you an opportunity to diversify your holdings beyond traditional investments and to hedge your portfolio against risk.
To be sure, investors are increasingly interested and active in the options markets. And while many of the general concepts are the same, some important differences exist between the options of individual stocks and those of a futures contract.
In this chapter, I cover the very basics of options on futures. This, though, is a highly complex topic which requires extensive space. My goal here is to expose you only to the rudimentary concepts so that you can have a base for further reading. At the end of the chapter, I provide some important sources where you can get more details.
Getting Options on Futures Straight
A futures contract is a standardized contract that calls for the delivery of a specific commodity at some time in the future. Thus, unlike options on stocks, in which you take delivery of a lot consisting of at least 100 (and possibly more) shares of stock, an option on a futures contract gives you the opportunity to buy or sell the futures contract, not the underlying commodity. So when you exercise or assign your option on a futures contract, you receive the contract, not the cash value of the index, the soybeans, or the gold.
Options on futures
Are always for one contract of the underlying commodity.
Require that you understand the underlying futures contract, be it for gold, soybeans, oil, or whatever, before you begin trading.
Trade in the same price units as the underlying futures contract, in most cases. That means that a one-point move in a stock index futures contract is a one-point move in the corresponding option. T-bond futures and options are an exception. The former trade in 32nds, while the latter trade in 64ths.
Don’t move on their own in price; rather, they move along with the underlying futures contract.
Can have quirky expiration dates. For example, March soybean options actually expire in February. What expires in March is the March soybeans contract, which is why the options are referred to as “March options.” The best thing to do is to look very carefully at a well-documented futures and options expirations calendar. You can get one from your broker, or see the December issue of Futures magazine for good calendars.
Offer round turn commission in many cases. This means that you only pay the broker when you exit your position, instead of paying to both enter and exit, as with stock options. Check with your individual broker for his practices.
SPANning your margin
Margin in futures and options on futures is different than margin on stocks. While margin in the context of stocks is a loan from your broker so you can buy stock worth more money than you have, margin in the former two is just the amount of money that you have to have in your account to trade futures and futures on options. Also, in terms of futures and options on futures, margin is a performance bond that earns interest if it’s held in the form of Treasury bills, as SPAN margin allows. (Keep reading for a definition of SPAN margin.)
Moreover, margin becomes important in options on futures if you want to implement more sophisticated strategies, such as writing spreads. Spreads are sophisticated techniques used by traders to make money in sideways markets. The value of the spread is derived from the difference in two or more assets. Spread trading is really beyond this chapter, but it’s an important aspect of options trading that you may want to look at as you gain experience.
SPAN stands for Standard Portfolio ANalysis of risk, a practice used in the exchanges where options on futures trade (the Chicago Board of Trade and the Chicago Mercantile Exchange) in order to determine the entire risk of a portfolio, including all futures and options held within it. SPAN is based on a sophisticated algorithm and is designed to help you make the best use of your trading capital.
The algorithm is designed to calculate the worst possible one-day move in all your positions. Then it automatically shifts the excess margin from any position(s) to new positions or those that don’t have enough. Here are some general details on margin for options on futures strategies:
Initial margin is just the amount needed to open the position. Margin requirements fluctuate on a daily basis.
A good rule of thumb for options writers is to have a 2-to-1 ratio of margin to net premium collected.
T-bill margins are valued at less than the actual value of the T-bills. For example, a T-bill with a $25,000 value gets a margin value between $23,750 and $22,500, depending on the clearinghouse. Still, the interest earned on such a T-bill may be good enough to offset some of your transaction costs, another good thing about SPAN. For more details on SPAN and options on futures, visit www.optionsnerd.com.
Types of options
Two types of options are traded. One kind lets you speculate on prices of the underlying asset rising, and the other lets you bet on their fall. Options usually trade at a fraction of the price of the underlying asset, making them attractive to investors with small accounts.
Calls
I think of a call option as a bet that the underlying asset is going to rise in value. The more formal definition is that a call option gives you the right to buy a defined amount of the underlying asset at a certain price before a certain amount of time expires. You’re buying that opportunity when you buy the call option. If you don’t buy the asset by the time the option expires, you lose only the money that you spent on the call option. You can always sell your option prior to expiration to avoid exercising it, to avoid further loss, or to profit if it has risen in value. Call options usually rise in price when the underlying asset rises in price.
When you buy a call option, you put up the option premium for the right to exercise an option to buy the underlying asset before the call option expires. Buying the call option gives you the right to exercise it. When you exercise a call, you’re buying the underlying stock or asset at the strike price, the predetermined price at which an option will be delivered when it is exercised.
Puts
Put options are bets that the price of the underlying asset is going to fall. Puts are excellent trading instruments when you’re trying to guard against losses in stock, futures contracts, or commodities that you already own.
Buying a put option gives you the right to sell a specific quantity of the underlying asset at a predetermined price, the strike price, during a certain amount of time. When you exercise a put option, you are exercising your right to sell the underlying asset at the strike price. Like calls, if you don’t exercise a put option, your risk is limited to the option premium, or the price you paid for it.
Puts are sometimes thought of as portfolio insurance because they give you the option of selling a falling stock at a predetermined strike price.
Types of option traders
Option buyers are also known as holders, and option sellers are known as writers.
Call option holders have the right to buy a stipulated quantity of the underlying asset specified in the contract. Put option holders have the right to sell a specified amount of the underlying asset in the contract. Call and put holders can exercise those rights at the strike price.
Call option writers have the potential obligation to sell. Put option buyers have the potential obligation to buy.
Breaking down the language barrier
You need to know several terms to be able to trade options. Most of this stuff is fairly simple after you get the hang of it. But if you’re like me, it isn’t much fun when you start. Still, if you’re going to trade options, you must dig in and get a grasp on the lingo, including these terms:
Premium: This is the price that you pay for the option. For options that you don’t exercise, this is the maximum risk.
Expiration date: This is the date on which your option expires. After this date, your option is worthless.
Strike price: This is the predetermined price at which the underlying asset is bought or sold.
In the money: A call option is said to be in the money whenever the strike price is less than the market price of the underlying security. A put option is in the money whenever the strike price is greater than the market price of the underlying security.
At the money: Options are considered at the money when the strike price and the market price are the same.
Out of the money: Calls are out of the money when the strike price is greater than the market price of the underlying security. Puts are out of the money if the strike price is less than the market price of the underlying security.
Grappling with Greek
Options require you to pick up a bit of the Greek language. You only need to know four words, but they’re all important. The Greeks, as they are commonly called, are measurements of risk that explain several variables that influence option prices. They are delta, gamma, theta, and vega.
John Summa, who operates a Web site called OptionsNerd.com (www.optionsnerd.com), summarizes the four terms nicely in an article he wrote for Investopedia.com. You can find it at www.investopedia.com/articles/optioninvestor/02/120602.asp.
But before actually getting into the Greek, you need to know the factors that influence the change in the price of an option. After that, I tell you how it all fits into the mix with the Greek terminology.
The three major price influences are
Amount of volatility: An increase in volatility usually is positive for put and call options, if you’re long in the option. If you’re the writer of the option, an increase in volatility is negative.
Changes in the time to expiration: The closer you get to the time of expiration, the more negative the time factor becomes for a holder of the option, and the less your potential for profit. Time value shrinks as an option approaches expiration and is zero upon expiration of the option.
Changes in the price of the underlying asset: An increase in the price of the underlying asset usually is a positive influence on the price of a call option. A decrease in the price of the underlying instrument usually is positive for put options and vice versa.
Interest rates, a fourth influence, are less important most of the time. In general, higher interest rates make call options more expensive and put options less expensive. Now that you know the major and minor influences on price, I can describe the Greeks.
Delta
Delta measures the effect of a change in the price of the underlying asset on the option’s premium. Delta is best understood as the amount of change in the price of an option for every one-point move in the underlying asset or the percentage of the change in price of the underlying asset that is reflected in the price of an option.
Delta values range from –100 to 0 for put options and from 0 to 100 for calls, or –1 to 0 and 0 to 1 if you use the more commonly used expression in decimals.
Puts have a negative delta number because of their inverse or negative relationship to the underlying asset. Put premiums, or prices, fall when the underlying asset rises in price, and they rise when the underlying asset falls.
Call options have a positive relationship to the underlying asset and thus a positive delta number. As the price of the underlying asset goes up, so do call premiums, unless other variables are changed, such as implied volatility, time to expiration, and interest rates. Call premiums generally go down as the price of the underlying asset falls, as long as no other influences are putting undue pressure on the option.
An at-the-money call has a delta value of 0.5 or 50, which tells you that the option’s premium will rise or fall by half a point with a one-point move in the underlying asset. Say, for example, that an at-the-money call option for wheat has a delta of 0.5. If the wheat futures contract associated with the option goes up ten cents, the premium on the option will rise by approximately five cents (0.5 × 10 = 5). The actual gain will be $250 because each cent in the premium is worth $50 in the contract.
The farther into the money the option premium advances, the closer the relationship between the price of the underlying asset and the price of the option becomes. When delta approaches 1 for calls, or –1 for puts, the price of the option and the underlying asset move the same, assuming all the other variables remain under control.
Is about 0.5 when an option is at the money and moves toward 1.0 as the option moves deeper into the money.
Tends to increase as you get closer to the expiration date for near or at-the-money options.
Is not a constant because the effect of gamma is a measure of the rate of change of delta in relation to the underlying asset.
Is affected by changes in implied volatility. (See the section “Understanding Volatility: The Las Vega Syndrome,” later in this chapter, for a full discussion of implied volatility.)
Gamma
Gamma measures the rate of change of delta in relation to the change in the price of the underlying asset. It enables you to predict how much you’re going to make or lose based on the movement of the underlying position.
The best way to understand this concept is to look at an example like the one in Figure 4-1, which shows the changes in delta and gamma as the underlying asset changes in price. The example features a short position in the S&P 500 September $930 call option as it rises in price from $925 on the left to $934 on the right and is based on John Summa’s explanation of the Greeks. The chart was prepared by using OptionVue 5 Options Analytical Software, which is available from www.optionvue.com.
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Figure 4-1: Summary of risk measures for the short December S&P 500 930 call option. |
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The farther out of the money that a call option declines, the smaller the delta, because changes in the underlying asset cause only small changes in the option premium. The delta gets larger as the call option advances closer to the money, which is a result of an increase in the underlying asset’s price. In this case, the more out-of-the-money the option is, the better it gets for the short seller of the option.
Line 1 of Figure 4-1 is a calculation of the profit or loss for the S&P 500 Index futures 930 call option — $930 is the strike price of the S&P 500 Index futures option that expires in September (as featured in Figure 4-3). The –200 line is the at-the-money strike of the 930 call option, and each column represents a one-point change in the underlying asset.
The at-the-money gamma of the underlying asset for the 930 option is –0.79, and the delta is –52.34. What this tells you is that for every one-point move in the depicted futures contract, delta will increase by exactly 0.79.
The position depicts a short call position that is losing money. The P/L line is measuring Profit/Loss. The more negative the P/L numbers become, the more in the red the position is. Note also that delta is increasingly negative as the price of the option rises.
Finally, with delta being at –52.34, the position is expected to lose 0.5234 points in price with the next one-point rise in the underlying futures contract.
If you move one column to the right in Figure 4-3, you see the delta changes to –53.13, which is an increase of 0.79 from –52.34.
Other important aspects of gamma are that it
Is smallest for deep out-of-the-money and in-the-money options.
Is highest when the option gets near the money.
Is positive for long options and negative for short options.
Theta
Theta is not often used by traders, but it is important because it measures the effect of time on options. More specifically, theta measures the rate of decline of the time premium (the effect on the option’s price of the time remaining until option expiration). Understanding premium erosion due to the passage of time is critical to being successful at trading options. Often the effects of theta will offset the effects of delta, resulting in the trader being right about the direction of the move and still losing money.
As time passes and option expiration grows near, the value of the time premium decreases, and the amount of decrease grows faster as option expiration nears.
The following minitable shows the theta values for the featured example of the short S&P 500 Index futures 930 call option.
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| T + 0 | T +6 | T + 13 | T+ 19 |
| Theta | 45.4 | 51.85 | 93.3 |
The concept of how theta affects the price of an option can best be summarized by looking in the fourth column of the table, where the figure for T + 19 measures theta six days before the option’s expiration. The value 93.3 tells you that the option is losing $93.30 per day, a major increase in time-influenced loss of value compared with the figure for T + 0, where the option’s loss of value attributed to time alone was only $45.40 per day.
Understanding Volatility: The Las Vega Syndrome
Vega measures risk exposure to changes in implied volatility and tells traders how much an option’s price will rise or fall as the volatility of the option varies.
Vega is expressed as a value and can be found in the fifth row of Figure 4-1, where the example cited in the figure shows that the short call option has a negative vega value — which tells you that the position will gain in price if the implied volatility falls. The value of vega tells you how much the position will gain in this case. For example, if the at-the-money value for vega is –96.94, you know that for each percentage-point drop in implied volatility, a short call position will gain $96.94.
Implied volatility (IV),
which is the estimated volatility of a security’s price in real time, or as the option trades. Values for IV come from formulas that measure the options market’s expectations, offering a prediction of the volatility of the underlying asset over the life of the option. It usually rises when the markets are in downtrends and falls when the markets are in uptrends. Mark Powers, in Starting Out In Futures Trading (McGraw-Hill), describes IV as an “up-to-date reading of how current market participants view what is likely to happen.”
Historical volatility (HV), which also is known as statistical volatility (SV), is a measurement of the movement of the price of a financial asset over time. It is calculated by figuring out the average deviation from the average price of the asset in the given time period. Standard deviation is the most common way to calculate historical volatility. HV measures how fast prices of the underlying asset have been changing. It is stated as a percentage and summarizes the recent movements in price.
HV is always changing and has to be calculated on a daily basis. Because it can be very erratic, traders smooth out the numbers by using a moving average of the daily numbers. Moving averages are explained in detail in Chapter 7, which is about technical analysis. In general, though, the bigger the HV, the more an option is worth. HV is used to calculate the probability of a price movement occurring.
Most of the time, IV is computed using a formula based on something called the Black-Scholes model, which was introduced in 1973 (see the next section). The goal of the Black-Scholes model, which is highly theoretical for actual trading, is to calculate a fair market value of an option by incorporating multiple variables such as historical volatility, time premium, and strike price. I’ll let you in on a little secret here: The Black-Scholes formula alone isn’t very practical as a trading tool because trading software automatically calculates the necessary measurements; however, the number it produces, IV, is central to options trading.
HV and IV are often different numbers. That may sound simple, but there’s more to it than meets the eye.
In a perfect world, HV and IV should be fairly close together, given the fact that they’re supposed to be measures of two financial assets that are intrinsically related to one another, the underlying asset and its option. In fact, sometimes IV and HV actually are very close together. Yet the differences in these numbers at different stages of the market cycle can provide excellent trading opportunities. This concept is called options mispricing, and if you can understand how to use it, options mispricing can help you make better trading decisions.
When HV and IV are far apart, the price of the option is not reflecting the actual volatility of the underlying asset. For example, if IV rises dramatically and HV is very low, the underlying stock may be a possible candidate for a takeover. Under those circumstances, the stock probably has been stuck in a trading range as the market awaits news. At the same time, option premiums may remain high because of the potential for sudden changes with regard to the deal.
Many good options-trading programs are available. Among the most popular programs is OptionVue 5 Options Analysis Software. This program has been around since 1982, and it has just about everything anyone could want to analyze options and find trades. Many traders use OptionsVue and consider it the benchmark program.
Most programs on the market are good enough to generate decent data. You want to find the one that’s easiest for you to use and in the right price range. Technical Analysis of Stocks & Commodities magazine, www.traders.com, has excellent software reviews, and it conducts an annual readers’ poll to determine which programs its readers think are the best. This magazine/Web site is a good place to do your homework.
Some Practical Stuff
In the preceding sections, I tell you about the nuts and bolts of options. In this section, I give you a brief summary of some, but certainly not all, situations in which you might want to use options.
There are two basic reasons to choose options as a trading vehicle. One is that you have limited amounts of money and want to trade. And the other is that you are looking to combine leverage while limiting your risk. The second choice is the most sensible of the two, as it takes a lot of talent to turn a little money into a large amount by using options, although it can be done if you’re clever and talented. But if you could do that, you wouldn’t likely be reading this book.
The simplest options strategy is buying call options, as the upside potential is theoretically limitless, while the downside risk is your option premium. This is usually the first strategy that beginners use when they enter this sector and is best used when you are expecting the underlying asset to rally.
A second use of call options is option writing. In this case, you are looking to protect a long position by selling a call option to someone and collecting the premium. This works better in markets that are falling or moving sideways. In this case you’re hoping that the underlying market goes mostly nowhere and that the option expires worthless, while you pocket the premium.
Put option strategies are generally useful in falling markets, but tend to be more risky than call related strategies.
Other, more complex strategies, such as straddles, strangles, and spreads, involve two or more options, sometimes involve more than one asset class, such as stock index options being paired with bond options, and are beyond the scope of this chapter. See the section at the end of the chapter titled “Useful information sources.”
General rules of success
Become familiar with the underlying futures contract before you trade the options, and look at the two instruments simultaneously.
The following example, adapted from an article written by John Summa (optionsnerd.com), covers the S&P 500 stock index futures and related options. (If you’re going to trade soybean options, become familiar with the rules and vagaries of the soybean sector, and so on.)
Figure 4-2 summarizes the facts about the S&P 500 futures contract. Figure 4-3 shows you the settlement prices for three S&P 500 futures prices as they settled on June 12, 2002, and Figure 4-4 shows the closing prices of corresponding options on the same day.
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Figure 4-2: S&P 500 futures contract specifi-cations. |
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Figure 4-3: S&P 500 futures contract settlement prices June 12, 2002. |
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Figure 4-4: S&P 500 options prices at settlement on June 12, 2002. |
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Here’s what’s important: The June S&P futures contract in Figure 4-3 settled at 1020.20 on June 12. The contract gained 6.00 points, which is equivalent to a gain of $1,500 per single contract (6 × $250 = $1,500).
Looking at the options, note in Figure 4-4 that because the price of the contract rose, the price of the call options rose, and the price of the puts fell. Note also that the delta is positive for calls and negative for puts, and that the higher the delta value, the more the price of the underlying futures affects the option’s price change. The reverse applies to the put options, as the figure shows.
If you understand these rules, you can then apply them to your option strategies, which are of three basic types: buying puts or calls, selling (writing) puts or calls, or setting up more sophisticated strategies, such as spreads, strangles, and straddles.
The following tips are the best advice I can give you when it comes to options, or any kind of investment or trading in the futures markets:
Work out the kinks of your strategies on paper before you proceed.
Avail yourself of the best possible software and quote system possible for whatever you’re trading.
If you’re well prepared and you have good equipment and data, your chances of success will be much higher.
Useful information sources
Finally, here are some other places to get more details about options:
High-Powered Investing All-in-One For Dummies (Wiley). Check out Book III, focusing on futures and options, by yours truly.
Trading Options For Dummies by George A. Fontanills (Wiley).
Options as a Strategic Investment by Lawrence G. McMillan (New York Institute of Finance)
Options Made Easy, 2nd Edition, by Guy Cohen (Financial Times Trading and Investing)
The CBOE Web site (www.cboe.com)