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Option Trading Explained

Why have options on futures contracts become so popular among the investment class Mainly because they have a KNOWN and LIMITED RISK but they also have an UNLIMITED PROFIT POTENTIAL.
Option Trading Explained


Options on futures contracts have become an attractive investment for many individuals seeking to profit from significant price movements — either upward or downward — in today’s increasingly volatile and often uncertain investment environment. Approximately 300 million options, encompassing a wide variety of basic commodities and financial products, are traded annually on the nation's regulated exchanges. As the title states, this booklet has been prepared to provide plain-language answers to 25 important questions about purchasing options as an investment. Hopefully, they will become helpful in deciding whether options are for you. 

1.  What is my maximum risk if I buy an option? The nature and amount of downside risk is a good first question to ask about any investment you may be considering- In the case of options, the maximum risk is that you could potentially lose the money — known as the premium — which you invested to purchase that particular option and any brokerage and transaction costs involved in making the investment.. 

2. Doesn't this make options a risky investment? It makes options an inappropriate investment for some people. This is why your broker will ask you questions that may seem somewhat personal about your financial situation and objectives and will inquire that you acknowledge reading and understanding a Risk Disclosure Statement. This is important information and should be considered in deciding whether options are an appropriate investment for you. Money needed for family living, insurance protection, and basic savings programs obviously should never be committed to any form of investment that involves substantial risk, regardless of the opportunity for profit. 

3. Why have options on futures become such an increasingly popular investment? Options make it possible to realize a potentially substantial profit - perhaps in a short period of time - with a relatively small investment and with a known and limited risk. Under no circumstances can the loss exceed the cost of purchasing the option. Other advantages include:

The leverage inherent in options. The liquidity provided by established competitive option markets Investment diversification. The flexibility to respond rapidly to any Market Opportunities The ability to follow the value of your investment on a day-to-day basis. The staying power to weather temporary price setbacks without incurring additional risk or costs. Freedom from the margin calls that many other investments are subject to The opportunity to realize profits during periods of declining prices as well as during periods of rising prices. 

4. What exactly is an option? There are exchange trading in two types of options on futures contracts, known as call options and put options. Which one to consider investing in will depend entirely on your price expectations. That is, on whether you expect the price of a particular commodity to go up or whether you expect it to go down.

a. Call option. Purchasing a call gives you a specific locked-in price at which you have the right — but not the obligation — to buy a futures contract on a commodity that you expect to increase in value. Thus, if you look for, say, the price of gold to go up, you'd buy a gold call option. You can sell at any time during the life of your option

b. Put option. Purchasing a put gives you a specific locked-in price at which you have the right — but not the obligation — to sell a futures contract on a commodity that you expect to decrease in value. Thus, if look for the price of gold to go down, you'd buy a gold put option. Once again you can sell these options at any time during the life of the contract. One easy way to remember which is which is to think of the terms “CALL UP and PUT DOWN”. A call is a way to profit if prices go up. A put is a way to profit if prices go down.

If and when the market price of the commodity moves in the direction you anticipated, this will be reflected on a day-by-day basis in the value of your option rights. The more valuable your option rights become, over and above what you paid for them, the larger your profit will be when you decide to sell or exercise the option. 

5. Other than "call" and "put", what terms do I need to be familiar with? Just a couple. You should know what’s meant by an option’s “premium” and by its “strike price”. a. Premium. Used in connection with options, premium has the same meaning as when used in connection with insurance. It's the price that you pay to buy a given option. (See question 11 for an explanation of how option premiums are determined) b. Strike Price. This is the specific dollars and cents price at which the option gives you the right to buy a particular commodity in the case of a call or to sell the commodity in the case of a put. The strike price is stated in the option Example: If a call option gives you the right to buy 100 ounces of gold at a price of $300 an ounce, $300 is the strike price. At any given time, there is likely to be trading in options with a number of different strike prices. 

6. How are profits realized in option investing? Generally by instructing your broker to sell your option rights to someone else (who may expect them to further appreciate). The sale will be accomplished on the trading floor of the exchange (the same exchange where the option was bought) and your net profit will be the difference between the price that you originally paid for the option and the higher price that you are able to sell it for, less brokerage and transaction expenses. The mechanics are no more complicated than, for example, selling shares of common stock that have appreciated. An alternative to selling a profitable option is to exercise the option rights yourself. Doing this, however, would result in your actually acquiring a position in the futures market — which could require an additional investment on your part and involve significantly greater risks. Most investors therefore prefer to realize their profits by simply selling the option at its increased value. As an example, suppose I buy an option to purchase 100 ounces of gold at a strike price of $300 an ounce and the price of gold goes to $330 an ounce, what's my profit?

If gold climbs to $330 an ounce at expiration, your call option will have a value of $3,000 — the $30 an ounce price increase times 100 ounces. The profit will depend on what you paid for the option to staff with. If your total costs (premium plus brokerage commission) were, say, $700, then your profit will be $2,300, the difference between the $700 you paid for the option and the $3,000 you can now sell it for. As mentioned, the same broker who handled the purchase can handle the sale. (Question 17 has more information about selling a profitable option). Illustration of a profit or loss on 100-ounce gold call option if option strike price is $300 an ounce and the cost of purchasing the option was $700 ($7 an ounce).

If gold futures Value of option at Cost of option Your profit price at expiration or loss expiration is: $300 or less $700 $700 loss $305 $500 $700 $200 loss $307 $700 $700 Break even $310 $1,000 S700 $300 rofit $320 $2,000 $700 $1,300 rofit S330 S3,ooo S700 $2,300 profit

7. How large is my profit potential when I buy an option? There is no upper limit on the opportunity for profit. The greater the price movement - provided it's in the direction you anticipated and provided it occurs during the life of the option - the larger the profit. As previously indicated, it is the combination of limited risk and unlimited opportunity that is a principal attraction of options as an investment vehicle. 

8. At the present time, what options can be purchased? The list of exchange-traded options has grown rapidly and now includes a broad range of agricultural commodities, precious metals, energy products, financial instruments, and foreign currencies now including BITCOIN. The following is a partial listing by category.

Time to expiration. All else being equal, an option with more time until expiration commands a larger premium than an option with less time until expiration. The longer option provides more time for your price expectations to be realized. 

Strike price. In the case of call options, it stands to reason that the most valuable options are those that convey the right to buy at a low price. Thus, all else being equal, a call option with a low strike price costs more to purchase than a call option with a high strike price. It's just the opposite for put options. The most valuable puts are those that have a high strike price. 

Volatility. Again, all else being equal, option premiums are usually higher when the markets are volatile. Volatile markets are considered more likely to produce the price movements that can make options profitable to own. 

9. Exactly how much does the price of the commodity have to change in order for me to realize a profit on the option? Fortunately, this important calculation is also a simple calculation a matter of addition or subtraction, depending on whether you are buying a call option or a put option. The only two factors involved are the cost of the option and the option's strike price. 

CALLS. To realize a profit on a call at expiration the market price of the commodity must be above the option strike price by an amount greater than your costs (costs include the premium invested to buy the option, brokerage commission, and any other applicable transaction costs) or the PREMIUM is HIGHER than your purchase price. You can sell at any time during the life of the contract. 

Example: In anticipation of rising prices, you invest $700 (the equivalent of $7 an ounce) to buy a 100 ounce gold call option with a strike price of $300 an ounce. For the option to become profitable at expiration, the price of gold must climb above $307. For each $1 an ounce it increases above that amount, your profit is $700 

PUTS. To realize a profit on a put at expiration the market price of the commodity must be below the option strike price by an amount greater than your cost or the PREMIUM of the option is at a higher price. You can sell at any time during the life of the contract Example: In anticipation of declining prices, you invest $700 (the equivalent of S7 an ounce) to buy a 100 ounce gold put option with a strike price of $300 an ounce For the option to become profitable at expiration, the Price of gold must decline below $293. For each $1 an ounce it declines below that amount, your profit is $100.

10. It's often said a major advantage of options is "leverage". What does this mean? Greater leverage, which options provide, means that even a small favorable movement in the underlying commodity price can yield a high percentage rate of return on your investment. Example: You've invested $700 to buy a three-month gold call option with a strike price of $300 and the price of gold has climbed to $328 The option that cost only $700 can now be sold for $2,800 — a net profit of $2, 100 in three months. Said another way, it took less than a 10% increase in the price of gold (from $300 to $328) to give you a 300% return on your $700 investment. That's leverage. 

11. But can't leverage work both ways, against as well as for you? That's true; the potential for a high percentage return on your investment should be weighed against the risk that — if the option does not become worthwhile to sell or exercise by expiration — you can lose your entire investment in that particular option. Even so, buying an option can involve much less dollar risk than the alternative of owning the actual commodity. Example: At the same time you spent $700 to buy a 100-ounce gold call option with a strike price of $300, your wealthy neighbor — also expecting an increase in the price of gold — plunked down $30,000 to purchase 100 ounces of gold bullion. If the price of gold unexpectedly drops to say, $270 at expiration, your option will be worthless and you would have lost $700 — 100% of your investment. Your neighbor, if he decides to sell the bullion, will incur only a 10% loss, be he will be out $3,000 compared with your $700 loss.

12. Once I've bought an option, will there be a continuing market for that option? There's generally an active market in outstanding options right up to the day of expiration. However, if an option is no longer deemed to have much, if any, chance of ever becoming worthwhile to exercise, there may not currently by any market for it.

13. Suppose an option I've bought very quickly becomes profitable. Do I have to wait until the expiration date to sell it? Absolutely not. When to sell such an option is entirely up to you. On the one hand, continuing to hold the option until nearer its expiration date could result in your realizing an even larger profit. But, on the other hand, an unexpected adverse price movement could result in a reduction in the value of the option. Deciding when to sell a profitable option is thus a "bird-in-the-hand" type of decision. a. somewhat technical point to bear in mind in making the decision is that in addition to whatever amount — if anything — that a given option would be worth to exercise, options that haven't yet expired normally also have what's called "time value". Specifically, time value is whatever amount other investors are willing to pay you for giving up your option rights prior to expiration. As you'd expect time value generally declines as the expiration date approaches. It is also influenced, prior to expiration, by futures price movements and market volatility. 

14. Can I sell an option even if it isn't currently worthwhile to exercise? The answer is yes if the option still has time remaining until expiration and if there is still active trading in that particular option. Whether the sale results in a profit or a loss will depend - as with any option — on whether you sell it for more or for less than you paid for it. b. favorable change in the price outlook or an increase in market volatility can make an option suddenly more attractive to other investors. If this results in an increase in its premium value, you may be able to sell the option at a profit even though it isn't yet (and may never become) worthwhile to exercise. In other situations, if prices so far haven't moved the way you thought they would, and if you no longer want to own the option, selling it prior to expiration can provide a way to recover some part of your initial investment. Such a decision should not be made hastily, however. The fact that you have until expiration for your original price expectations to be realized can give you greater "staying power" than other investors may enjoy. It is this "staying power”— the ability to weather what may prove to be only a temporary price setback - that is one of the principal advantages of investing in options. No matter how large the adverse price movement, your maximum loss is still limited to the cost of the option.

15. Can I follow an option's current market value on a regular basis? Yes, very easily. Options on futures contracts are traded on exchanges that have continuous electronic quotation systems. Business periodicals such as the Wall Street Journal and many major newspapers report actively traded futures prices and options premiums daily. You can also phone your broker who has computer access to current options premiums (or phone sources for direct online price reports). Being able to know at all times what your investment is worth is another attractive feature of exchange-traded options.

16. How much should I know about the underlying commodity in order to consider investing in options? The reason for buying an option is because you have an opinion about the probable price movement of a particular commodity. The opinion can be derived from your own knowledge or, as dealing with a brokerage firm in whose research and analytical abilities you have confidence. 

17. When I purchase an option, who is the person or entity on the other side of the transaction? More than likely, it's someone who engages in a highly speculative area of investment activity known as option "writing". Such investors are also sometimes called option "grantors" They stand to make money if— and only if — your option rights at expiration are worthless than you paid for them. In contrast to the limited risks and is inappropriate for most people. Do not consider it without thoroughly discussing the costs and substantial risks with your broker. 

18. Who assures payment on exchange-traded options contracts? When an option that you've purchased becomes profitable, the funds needed to pay you are collected (from the option writer on the other side of the transaction) on a daily basis. This is accomplished through the brokerage firms and the clearing organizations of the exchanges where options are traded. 

19. What brokerage commissions are involved in buying options? Brokerage firms differ in the services they provide, in their success in helping clients identify potentially profitable investment opportunities, and in the commissions that they charge. Provided commissions are stated in a clear and forthright manner, each firms in the securities industry do. Nevertheless, commissions are one variable in an option's profit equation and you should be satisfied that they are fair and reasonable in relation to the services and advice being provided.

20. What place do options have in an overall investment program? To start with, it should be said again that options have no place at all unless some portion of your total investment capital can legitimately be considered risk capital money you can afford to take calculated risks with in pursuit of a correspondingly larger profit potential. If that requirement is met, options might very well have a worthwhile place in your total investment program. While options aren't for everyone, a study by John Lintmer, PhD., of Harvard University found that including futures investments in a diversified stock and bond portfolio had the overall result of "reducing volatility while increasing return." 

21. How do options compare with other investments that involve similar risk and reward arithmetic? Obviously, no two or more investments have exactly the same risk-reward characteristics. One characteristic of options is that, to be profitable, the anticipated price movement has to occur within the time frame of the particular option you've selected. Having said this, however, options have a number of distinct advantages in addition to their limited risk. These include: 

The opportunity to profit whether the price of a given commodity is expected to go up (by buying calls) or go down (by buying puts). This advantage should be readily apparent to investors who have had recent and frequent reminders that prices in a dynamic economy can move sharply upward. Option profits can be realized in both market environments. Indeed, as easily in one as in the other. 

Diversification. Because of the leverage options provide, a given sum of investment capital can more readily be divided among a number of different market sectors simultaneously — such as oil, metals, crops, and interest rates. This diversification can improve your likelihood of "being in the right places at the right time."

Options may be the least expensive way to acquire an interest in just about any of the commodities on which options are available. For example, buying call options in anticipation of rising energy or livestock prices may be considerably less costly than the alternative of, say, purchasing an interest in oil wells of a cattle feedlot.

 


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