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This chapter is from the book

A Brief Introduction to Commodity Options

The theory and practice of option trading is diverse and sometimes complicated. Accordingly, it is impossible to do the topic justice in such a brief mention. The purpose of this section is to merely introduce the subject.

Options can be purchased outright, in conjunction with futures contracts, or even as a package with both short and long options of various types. There are no limits to the versatility of option trading. Commodity options provide a flexible and effective way to trade in the futures markets with various amounts of potential risk and reward. For example, through the combination of long and short calls and puts, investors can design a strategy that fits their needs and expectations; such an arrangement is referred to as an option spread.

The method and strategy should be determined by personality, risk capital, time horizon, market sentiment, and risk aversion. Plainly, if you aren’t an aggressive individual with a high tolerance for pain, you probably shouldn’t be employing a trading strategy that involves elevated risk. Doing so often results in panicked liquidation of trades at inopportune times and other unsound emotional decisions.

What Is an Option?

Before it is possible to understand how options can be used, it is important to know what they are and how they work. The buyer of an option pays a premium (payment) to the seller of an option for the right, not the obligation, to take delivery of the underlying futures contract (exercise). This financial value is treated as an asset, although eroding, to the option buyer and a liability to the seller. There are two types of options, a call option and a put option.

  • Call options. Give the buyer the right, but not the obligation, to buy the underlying at the stated strike price within a specific period of time. Conversely, the seller of a call option is obligated to deliver a long position in the underlying futures contract from the strike price if the buyer opts to exercise the option. Essentially, this means that the seller is forced to take a short position in the market when the option is exercised.
  • Put options. Give the buyer the right, but not the obligation, to sell the underlying at the stated strike price within a specific period of time. The seller of a put option is obligated to deliver a short position from the strike price if the buyer chooses to exercise the option. Keep in mind that delivering a short futures contract simply means being long from the strike price.

Similar to futures contracts, there are two sides to every option trade: a buyer and a seller. Option buyers are paying for the underlying right, whereas sellers are selling that right. The most important point to remember is that option buyers are exposed to risk limited to the amount of premium paid, whereas option sellers face theoretically unlimited risk. Conversely, option buyers have the possibility of potentially unlimited gains, whereas the profit potential for sellers is limited to the amount of premium collected (see Table 1.1).

Table 1.1. Relationship Between Calls and Puts

Call

Put

Buy

bull.jpg

bear.jpg

Limited risk

Sell

bear.jpg

bull.jpg

Unlimited risk

Traders who are willing to accept considerable amounts of risk can write (or sell) options, collecting the premium and taking advantage of the well-known belief that more options than not expire worthless. The premium collected by a seller is seen as a liability until either the option is offset (by buying it back) or it expires.

Option Spreads

The majority of beginning option traders prefer trading outright options (buying or selling calls or puts), due to their simplicity. However, there are definite advantages to becoming familiar with the flexibility of risk and reward when using option spreads.

An option spread is the combination of two different option types or strike prices to attain a common goal. The term option spread can be used to refer to an unlimited number of possibilities. For example, an option spread can involve the purchase of both a call and a put with the same strike prices, or it can be the purchase and sale of two calls with different strike prices. The sheer number of possibilities makes this topic beyond the scope of this book, but if you are interested in learning more on option spreads, you might want to pick up a copy of Commodity Options, which I authored and was published by FT Press.

To add to the confusion surrounding commodity vocabulary, an option spread has its own bid/ask spread. Just as a single call or put would have a price that you can buy it for and a price you can sell it for, a spread is priced as a package and has both a bid and an ask that represent the purchase or sales price for the combination of options.

Fortunately, when dealing with a spread on a spread, most insiders identify the bid/ask spread by its full name and also refer to the option spread by its specific name. For example, if a broker calls the trading floor to get a quote for an option spread, she might say something like this to the clerk who answers the phone: “Will you get me the bid/ask on the 900/950 call spread?” Similarly, when accessing an option spread quote via an electronic trading platform, a trader inputs the appropriate strike prices and designates the query as a “vertical call spread,” or some other type of recognized spread structure.

It is important to realize that, when getting a quote for an option spread, it isn’t necessary to decipher whether you will be buying or selling the spread. This is because the broker or trading platform gives you the quote for doing each. Therefore the bid/ask spread—the spread can be bought at the ask and sold at the bid.

Once again, option spreads are too complex to discuss in any detail within this text. However, you need to realize that, when it comes to option spreads, if the price of the long option of the spread is higher than the price of the short options, the trader is buying the spread. If it is possible to collect more premium for the short legs than is paid for the long legs, the trader is selling the spread.

The increasing popularity of electronic trading platforms, and the resulting transparent option pricing, has encouraged many traders to place separate order tickets on various legs of their spreads instead of entering a single ticket to enter the trade as a package. For instance, an option spread between a long and a short call option could be entered using a spread order in which both legs are executed simultaneously. Alternatively, a trader could simply place an order to buy the desired call option, and then another to sell the other call option to complete the spread.

For margin purposes, option spreads are treated the same whether they are entered on one ticket or multiple tickets. However, some brokers with strict order entry risk policies might prefer traders to enter spreads on a single order ticket so that they know the trader’s intention before approving and executing the order. In other words, overactive risk-management desks might reject certain orders intended to be a part of a spread due to misunderstood risk and margin consequences.

In conclusion, traders are doing themselves a disservice by ignoring the potential benefits of incorporating option trading into speculation. Although option trading can seem complex on the surface, you owe it to yourself to be familiar with all the tools available to you as a trader. After all, taking the “easy road” in life often fails to be beneficial in the end, and this may be no different.

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