Trader Toolbox: Learning Options Part 1 of 5

Options on futures have come of age. In fact, at some exchanges, options trading outstrips growth in futures trading by a 2:1 margin. But this growth has a major flaw: Many people use options for the wrong reasons. Sound options trading begins with understanding basic concepts and dispelling common misconceptions about he potential benefits and limitations of these instruments.

The Basics - An option contract gives you the right to buy or sell something at a set price for a limited amount of time or at a specific future date. Options are common in many businesses, such as real estate, where an investor might purchase an option that will give him the right to buy a parcel of land at an agreed upon price for a six-month period, regardless of fluctuations in the market price of the land.

Options on futures are no different. A trader can buy an option in June allowing him to buy December T-bond futures at 100.00, even if the market price in December is 105,00. The buyer pays a price for this opportunity, called the premium. The option buyer is sometimes called the writer.

There are two kinds of options: calls and puts. A call option gives the owner the right to buy futures at a specific price; a put option gives the owner the right to sell futures at the specific price. This predetermined price is called the exercise price, or strike price. A call option owner who "exercises" his right becomes long futures, while an option seller is "assigned" a short futures position. When a trader sells an option, he risks having a losing futures position at any time. In return for assuming this risk, he receives the option premium.

The owner, on the other hand, is under no obligation to exercise, and may sell the option or hold it through the term of the agreement. The last day a buyer can exercise an option is called the expiration date, which is established by the exchange. For example, the owner of a March 445 S&P call call buy March S&P futures at 445.00 until March 17, if he so chooses. The option expires at the end of trading on this day.

Most listed options in the United States are American style options, which allow the holder to exercise any time up through expiration day. European style options can be exercised on expiration day only.

Ins and Outs - The strike price of an option can be described three ways:

In-The-Money refers to calls with strikes prices below the current market price of the underlying future and puts with strike prices above the market price. If coffee futures are trading at 195.00. a 194.00 call is in-the-money, as is a 196.00 put.

At-The-Money options are calls and puts with strike prices equal to the current futures price. If coffee is 197.00, both 197.00 coffee calls and puts are at-the-money.

Out-Of-The-Money refers to calls with strike prices above the current futures price, and puts with strike prices below the future price. With coffee at 194.00, a 195.00 call and a 193.00 put would both be out-of-the-money.

With March bonds at 100.22, the owner of a March 98.00 call could exercise his option, become long bond futures at 98.00, sell the futures at 98.00, sell the futures and make 2.22. If the trader paid less than 2.22 for the opions, he would make a profit on the trade.

Because option buyers are not required to exercise, their market exposure is limited to the premium paid for the option. For sellers, however, risk is equivalent to an outright futures contract, because they can be assigned a futures position at any time.

Straddling Options

The post below is from Eric at The Stock Market Prognosticator. Free free to leave a comment or let him know if you have any other option tips you would like him to write about.


It is important for investors not panic during the current market volatility. Money can be made on both the upside and downside. One of the strategies I employed recently involves using options to take advantage of this volatility. During the month of July, I opened "straddle" positions on six different stocks and ETF's. I closed all of them out at a profit within two weeks.

So here is how it works, a straddle is the simultaneous purchase of an equal number of both calls and puts on the same underling stock, ETF, or index. Both the calls and the puts should have the same strike price and same expiration.

What I am looking for is a large move by the stock before the options expires. I am indifferent as to which way the market moves, as long as the combined premium when I close it out is more than the combined premium that I paid.

Here are some other things to know:

1) Make sure that the options have several weeks to expiration so there is time for the underlying instrument to move.

2) Pick only options with large volume and narrow spreads, a few pennies per contract is best.

3) Be careful about using this strategy when the underlying instrument has very high-implied volatility, as all other things being equal, a high implied volatility leads to a higher option premium. If this implied volatility suddenly dissipates then one side of your position may drop sharply in price.

4) I usually wait until the underlying instrument is trading right at the strike price, so the options cast per contract is roughly the same.

Here is an example of one of my trades:

I purchased the Financial Select Sector SPDR (XLF) July 21 Calls and July 21 Puts at a price per contract of $1.14 and $1.13 respectively. This position was opened prior to the huge rally in financials last week. Four days later I closed the position out, selling the calls at $2.28 and the puts at $0.51 per contract. The profit before commissions per contract was $0.53, or $53.00. So a round lot of 100 contracts would have yielded a profit of $5,273 in less than a week.

Investing in options carries a lot of risk, so please decide yourself whether a strategy like this is correct for you as an investor.


If you would like to learn more about my investment philosophy, then please visit The Stock Market Prognosticator.