Many people are intimidated by the unlimited risk potential when trading futures contracts. Margin calls can and do happen when trading futures or granting naked options. Long options have limited risk and many investors choose them to trade over commodities futures contracts for that reason. Your maximum risk when purchasing an option is loss of the premium paid plus your commission and fees.
Therefore your account can't go negative as can happen in a futures contract. An option gives the purchaser the right but not the obligation to buy or sell a futures contract, at a predetermined price strike price on or before a predetermined expiration date. To go long buy an option requires a buyer holder to pay a premium. When going short an option, the seller writer or grantor receives a premium but is liable for the entire contract value.
Therefore option grantors' risks are similar to that of a futures contract trader. Click here to learn more about selling options on futures contracts. What is a call option? A call option gives the purchaser the right but not the obligation to buy an underlying futures contract. Purchasing a call means that you are expecting higher prices for the underlying commodity.
What is a put option? A put option gives the purchaser the right but not the obligation to sell an underlying futures contract. Purchasing a put means that you are expecting lower prices for the underlying commodity. How is the value of an option figured out? To understand option trading basics first you have to understand the meaning of intrinsic and extrinsic value.
The option premium is made up of both of these values. Intrinsic is the value of the option if you exercised it to the futures contract and then offset it. For example if you have a Nov. Extrinsic value is made up of time value, volatility premium and demand for that specific option. If the option has 60 days left until expiration it has more time value than it would with 45 days left.
If the underlying futures contract has large price movements from low to high the volatility premium will be higher than a contract with small price movements. If many people are buying that exact strike price, that demand can artificially push up the premium as well. What is time decay? Options are by definition a wasting asset because each and every day the option's premium is being eroded by time.
This erosion of premium accelerates throughout the lifespan of the option. Time decay is the best friend of option sellers and the worst enemy of option purchasers. The value of out-of-the-money options is composed almost entirely of time value.
The chart below depicts the acceleration of the time decay of an option with a 9 month lifespan from its inception to its expiration. How much will an option premium move in relation to the underlying futures contract?
You can approximate the move by finding out the delta factor of your option. The delta factor tells you how much the change in premium should occur in your option based on the underlying future contract's movement. Let's say that you think Dec.
You bought an option with a. Can an option speculator have a profit before the option has intrinsic value? Yes, as long as the option premium increases enough to cover your transaction costs such as commission and fees. Conversely, the underlying futures market for your options can move the direction that you anticipated but not quickly enough to offset the time decay of the options.
So, options can lose money in spite of the underlying futures contract moving in a favorable direction. What is a bull call spread? A bull call spread is a bullish strategy to take advantage of markets with high volatility option premiums.
It involves the purchase of a at or close to the money call option and the granting of a further out of the money call option. The profit potential is the difference between the strike prices minus your costs and your risks are the cost of the trade. What is a bear put spread? A bear put spread is just like the bull call spread above but it uses puts instead of calls and is for speculating on a decline in prices. So you would buy an at or near the money put and grant a further out of the money put.
Here is the introduction to futures guide from the CME Group. What is a futures contract? The unit of exchange that trades in the exchanges is the futures contract. Each contract provides for the future delivery of goods at a specified date, time, and place.
Each particular commodity is bought and sold in standardized contractual units, which makes them completely interchangeable. How old and how useful are the commodities markets? The modern futures markets have been traded since rice futures traded in the eighteenth century in Osaka, Japan. However, historians have found some evidence of primitive futures contracts for olive oil, spices and other goods were used by shipping merchants in Persia before Christ.
In the United States futures trading began in the mid-nineteenth century with corn contracts in Chicago and cotton contracts in New York. The industrial revolution brought a new technology and the ability to produce more efficient tools and consequently more food. Economic output not only began to keep pace with the growing population but also increased the standards of living. This new productivity called for more agricultural storage, transportation, and more efficient distribution of goods.
At first the cash markets could handle the growing demand, but as quantities increased, the futures markets with uniform commodity pricing, grading, and delivery, became increasingly important. To cope with the gluts that occur during harvest times and with the shortages that occur before the harvest, purchasers could now protect themselves from price fluctuations by locking in a specific price for a commodity before they actually needed it.
So futures and options became necessary for producers, consumers and investors. Why do people invest in commodities? Leverage is very important to the commodities markets. Unlike the stock market, where you might have to invest 10, dollars to leverage 10, dollars of a particular stock. A commodities trader can leverage tens of thousands of dollars worth of a commodity for pennies on the dollar.
Also unlike stocks, commodities have intrinsic value and will not go bankrupt. The futures markets are so crucial to the well being of our nation, that the government established the Commodity Futures Trading Commission CFTC to oversee the industry. There is also a self-regulatory body, the National Futures Association NFA , who monitor the activities of all futures market professionals to ensure the integrity of the futures markets. Commodities also give the investor the ability to participate in virtually all sectors of the world economy and have the potential to produce returns that tend to be independent of the stock, bond and real estate markets.
In fact portfolios that add commodity investments can actually lower the overall portfolio risk by diversification. What is the difference between hedging and speculating? Just about every product that you consume would likely cost dramatically more without the commodities futures markets. This shifting of risk to someone willing to accept it is called hedging. Manufacturers could effectively lock in a sales price by going short an equivalent amount of goods with futures contracts.
If a mining company knew that they were going to sell ounces of gold in several months, they could protect themselves for a future price decline by going short 10 gold futures contracts or 10 gold put option contracts today. The futures price will eventually become the cash price. A user or buyer of goods can use the futures market in the same manner. They would need to protect themselves from a future price increase, and therefore go long futures contracts.
The person willingly accepting a risk does so because of the opportunity to profit from price movements, this is known as speculating. The cotton in your shirt, the orange juice, cereal and coffee you had for breakfast, the lumber, copper and mortgage for your home, the gas or ethanol that you put in your car all would be priced many times higher without the participation of speculators you in the futures markets.
Through supply and demand market forces, equilibrium prices are reached in an orderly and equitable manner within the exchanges, and world economies, and you, benefit tremendously from futures trading. What if I am not a large producer or consumer of a commodity and I just want to hedge my stock and bond portfolio?
The same thing applies to protecting your stock and bond portfolios from adverse market moves. If you are worried about higher interest rates hurting your fixed income investment prices, once again, you can short the futures or buy puts on your Treasury Bills, Notes and Bonds.
What does going long and going short mean? To make a profit on any investment requires that something be bought and sold. If you were bearish you would sell, or go short. If you were bullish you would want to buy, or go long.
When trading futures, you never actually buy or sell anything tangible; you are just contracting to do so at a future date. You are merely taking a buying or selling position as a speculator, expecting to profit from rising or falling prices.
You have no intention of making or taking delivery of the commodity you are trading, your only goal is to buy low and sell high or vice-versa. Before the contract expires you will need to relieve your contractual obligation to take or make delivery by offsetting your initial position.
Therefore, if you originally entered a short position to exit you would buy, and if you had originally entered a long position, to exit you would sell. How do trades take place? Chicago Mercantile Exchange and most other U. Broadly speaking, trading is essentially the same in either format: Customers submit orders that are executed — filled — by other traders who take equal but opposite positions, selling at prices at which other customers buy or buying at prices at which other customers sell.
This matching of buyers and sellers occurs in both open outcry and electronic trading, but there are some differences between the two processes.More...