 |
 |
|
| What is an Option? |
|
| An option will give the buyer the right, but not the obligation, to exercise and buy or sell the futures contract at a strike price when the option goes into the money anytime before a specified expiration date. |
|
I am going to spend some time to explain the basics of option trading and why it's a good investment vehicle. Options are a good tool for investing, because if you are the buyer of options you give yourself limited risk and unlimited potential. If you are the seller of options you have unlimited risk and limited potential. I will go over both strategies and give examples at the end of this article.
|
|
|
| There are 2 options: Calls and Puts. If you believe that a particular market is going to move higher you would want to buy calls or sell puts. If you believe a market will move lower you would like to buy puts or sell calls. Options also have expiration dates that you must be aware of. An option loses value as time goes by and this is called time decay.
|
|
|
| I could spend all day defining option terms, but it isn't very exciting. I would like to get right into option trading with some hypothetical examples. I believe you will learm more by seeing specific examples and by me breaking down an option trade step by step. |
|
| Buying a Call |
|
| If you think a market will move higher, but you aren't sure when this will occur. The Corn market is near an all time low. Let's say you believe that Corn will eventually move higher. The only reasoning you have is what goes up comes down and what comes down goes up. Basically you are bucking the trend. You are picking a bottom and picking a bottom is all timing. Buying low and selling high is easier said than done. When you are buying an option you have three rights. |
|
| Sell your option for a profit or a loss |
|
| Hold the option until expiration |
|
| Exercise your option |
|
| The future price of Corn is 195. You want to buy a call that will cost you about $500 and you would like to have 6 months on this trade, so you can give the Corn market some time to find a bottom. There is a September Corn 230/call for $500, expiration is 8/26. This is exactly what you are looking for, an option that will cost you $500 and has a little over 6 months, so you buy this particular option. Buying a call option you will have limited risk and unlimited potential. There is one of two things that will occur after the purchase of this option. You will make money or you will lose money. |
|
| Make Money |
| After the purchase of this option the Corn market makes a dramatic move on the upside. There is strong demand for Ethanol, because the price of Gasoline is at all time highs. They use Corn for the production of Ethanol. The demand for Corn increases dramatically. The Corn is trading at 350, so your 230/call goes into the money by 120. This is equivalent to 6K profit - the cost of the option($500)! You weren't expecting anything like this, but you will certainly take it. You offset your option. |
|
| You also have the right to exercise your 230/call |
|
| You exercise your 230/call. You will have a long future position at 230. If the future price for Corn is at 350, you will be up 6K - the cost of the option($500). Nice Trade! |
|
| Lose Money |
| After the purchase of this option the Corn market doesn't move. It continues to hover around 230 and as time goes by your option loses value. Let's say you want to remain on the ship before it sinks or sails. On the expiration date of this option the Corn future price settles below 230. Unfortunatley you were wrong and this option expired worthless. You would lose the premium you paid for the option, $500. Keep in mind, if you would like to get off the ship early and sell your option you will not lose the entire value of this option. You may not get much, but you should receive something. The later you hold the option the less money you will get back, time decay. |
|
|
| Selling a Call |
|
|
|
Let's say you believe a particular market will move lower, but you are not sure when this will occur. The Eurocurrency is around all time highs and you believe the Eurocurrency has to come down soon. You want to sell a call that has 2 months left for about a $1000 credit. You want to take advantage of time decay and from a downside correction from overbought all time highs. When you are selling calls three things could happen.
|
|
|
|
Buy back the option you sold for a profit or a loss |
|
|
|
Hold the option until expiration |
|
|
|
Get assigned on your short option sell |
|
|
|
The future price of the Eurocurrency is at 13000. You look to sell a call option that has 2 months of time left and a credit of $1000. There is a April Eurocurrency 132/call that you would receive a credit of $1000. Selling a call will give you unlimited risk and limited potential. There are 2 things that will occur with this trade. You will either make money or lose money.
|
|
|
|
Make Money
|
|
After the sale of this option the Eurocurrency hovers around 13000 for a few weeks and than makes a sharp move to 13300. This scares you, but you stick with your position. On the expiration date in 2 months the Eurocurrency settles at 12990. You get to keep the entire $1000 credit you received by selling this option. This trade is interesting, because you were wrong when it made a sharp rally and you still made money. You stuck to your guns and didn't take the loss when it went against you. You only have limited potential and unlimited risk. The odds are in the sellers favor, because they say 80% of options expire worthless. Options are a wasting asset, they lose value rapidly with time decay.
|
|
|
|
Lose Money
|
|
You sell this particular Eurocurrency call option for a credit of $1000. After the sale of this option there is some news that comes out that Europe want to start pumping up their Currencies value. The Eurocurrency moves from 13000 to 13500 almost instantly. This trade has moved above your 132/call strike price by 300 points. You decide that you want to exit this trade. You buy back the call. The call cost you $3000 to buy back. You would lose $2000, because initially you collected $1000.
|
|
|
|
Getting assigned with your short option.
|
|
|
|
You sold the 132/call Eurocurrency call to the buyer. The buyer decides he would like to exercise the 132/call that you sold to him. The buyer of the option would have a long future position at 13200 and you, the seller, would have a short future position at 13200. The future is at 13500. You do not want to be short the Eurocurrency after what Europe said about pumping up the value of their Eurocurrency. You buy back your short future position at 13500 and lose 300 points or $3750.
|
|
|
|
*The same holds true with buying or selling Put options.
|
|
|
John Garrity |
|
|
