From the December 01, 2007 issue of Futures Magazine • Subscribe!

Understanding options

Options are vehicles to take you where you want to go. As a new trader, do not look to them to tell you where the market is going. You are the driver. Options are simply a tool you can use to exploit your analysis of the market in unique ways.

Most would-be option traders get started with futures, and it can help to view options relative to futures. There are many trade-offs between futures and options. When you understand how options work and know the right strategy for the given time frame, they can help you avoid some of the pitfalls of futures trading. Some of those include implementing a trade with an improper risk/reward outlook, getting stopped out, emotional decisions, poor money management and letting a bad trade become worse.

What are options? Call options are contracts that give the buyer the right, but not the obligation, to buy the underlying market at a stated price (the “strike price”) before or on some date in the future (the “expiration date”). Put options are contracts that give the buyer the right, but not the obligation, to sell the underlying market at a stated price before or on some date in the future. The option seller takes the opposite side of the position. That is, he assumes the obligation to sell or buy the underlying if the strike price is met. The option buyer pays the option seller the option premium for assuming

this liability.

With active and liquid markets in hundreds of options available today, it is possible for individual investors to buy and sell these contracts in seconds — just as easy and fast as you can with stocks or futures.

However, despite their benefits, unless you know how to use options properly, they will not help you. Indeed, an improperly applied option-based strategy can create greater losses than a futures-based position. With options, you can be “right” the market and still lose money if your position is constructed wrong. However a properly constructed position can allow you to profit even when you are “wrong” the market. The proper strategy and the discipline to apply it are a big part of being successful.

WHO SHOULD USE OPTIONS?

Small or large accounts can benefit from option trading, but an account under $25,000 has more reason to use them. Many markets can move $4,000 in a week per one futures contract, which would be too big a percentage of risk for a small account. Options give an advantage to controlling risk that futures alone do not have.

Imagine being caught in a limit move against you with a futures contract. Now you are in jeopardy of losing more than you thought because the market has opened well past your stop. You are stuck with the position and can’t get out. This cannot happen when you buy an option. When you buy an option, your loss is limited to what you already paid for the option itself.

In a nutshell, options lose less as the underlying futures price moves against the position, and options gain at a higher rate of return when the underlying moves with the position.

Options allow you to use them exactly as you want to fit your thoughts, ideas, and time frame. Using a standard selection of option-trading strategies, you can make money if the market goes nowhere, explodes up or down, marches in one direction, and even if you are partially wrong on your market analysis. Futures do not offer that benefit. What futures offer is, in general terms, a much more liquid market (except for the highly traded options) and the satisfaction that some receive for knowing whether they are right or wrong starting from the next tick after entry.

THE ROLE OF ANALYSIS

While options strategies are enormously flexible, market analysis still plays an important role. To obtain the best results with his options positions, the option trader must be a market strategist.

Being long option premium strategies limits the risk, while futures present the hazard of uncontrollable, unlimited loss. An important part of trading successfully is controlling this risk. Does the price prove you wrong so you get stopped out, or did the position not have enough time because of the risk of staying in a losing trade? If you had more time and limited risk, could that trade turn around and become profitable? What options allow is the time and flexibility to better manage the downside of the trade. There is no going to bed wondering how bad your position might be tomorrow, and whether you can absorb the loss. Options give you the time needed to see if your idea works without the risk, or fear, of unlimited loss.

Instead of futures that need an exit (stop loss) to control and prevent further losses, options have a built-in stop: the premium you paid, and with that, you buy more time to find out if your analysis will prove correct before you make an emotional decision to pull the plug on the position before it’s ready.

ANOTHER LEVEL

Although the loss management as described above is based on the personal and subjective role of emotions, there are universal, objective and tangible benefits from slightly more advanced option strategies.

For example, a common option strategy is a vertical call spread. In this strategy, the trader purchases a call option with one strike price and sells a call option with a different strike price. The bullish version of this strategy would involve buying the lower-strike call and selling the higher-strike call.

The call option with the lower strike price costs more than the call option with the higher strike price. Therefore, the trader would have a net debit for establishing this position. The net debit is the maximum loss that is possible on the trade. This trade makes a profit if the underlying closes above the lower strike price, minus the cost of the transaction. The maximum profit is the difference between the strike prices of the two options (see “Vertical profits,” above).

Consider this example. If gold is at $650 per contract and you buy a 700 call for $1,100 that expires in six months and the market goes to $695, on expiration day, your 700 call is worthless. You just took a $1,100 loss. If you had bought the $650-$700 vertical call spread for about $1,400 instead, you would have made $3,100.

The naked 700 call had an unlimited pipe-dream profit potential, and the spread was more realistic with a limited profit. The $700 call would need the underlying to hit $747 to make a $3,600 profit, but would have unlimited profit above. The spread needs a futures price of $700 to make $3,600. So, for the price of forsaking those pipe-dream profits, you received a much higher probability that your position would profit.

Also, it’s worth repeating, unlike a futures contract, the vertical call spread has a known risk and a known time frame for success. This, again, gives you the confidence to stay in a trade without the possibility of losing more than you paid for it. If the market price of gold went down $45 in a week (a $4,500 loss per futures contract), you might have been stopped out. However, with your maximum loss potential fixed, you are still in the option trade without fear of unlimited losses and still have the time to see if the market can turn around and become a profitable trade.

Options give an advantage to controlling risk that futures alone do not have. Even if you wanted to buy an option to protect an existing futures position, that would be two trades, two commissions, two entries and two exits, when the same would be accomplished, but with a better risk profile, with the simple purchase of an intrinsic option.

An intrinsic option will act just like a futures contract, minus the premium paid, if you are right the market. If wrong, it can only lose the amount paid for the option no matter how much the market moves against you. It’s like buying built-in discipline not to let your losses run against you. The loss of this premium is usually less than the futures stop loss and buys you the time for a turnaround without the worry of further loss. These options will act more like a futures contract with more profit as you are right, and act less like a futures contract and lose less money in relation to a futures contract if the market goes against you.

BE THE HOUSE

As you may have already noticed, there are two sides to every option position. By assuming one side, you are betting on a bigger return with a smaller chance of that return becoming a reality. By assuming the other side, you are betting on a smaller return, but with a much higher chance of success.

Assume that the S&P 500 is at 1540.00 and analysis suggests that the market is going to be lower than 1520.00 in four weeks. The first approach that most traders take is to buy the 1540/1520 vertical put spread for about $2,450. Alternatively, you could sell the 1540/1560 vertical call spread for the same $2,450. The difference is that if you buy the put spread you must be right for 980 points to be even, and selling the call spread you don’t even have to be right to still make $2,450—or some part thereof.

Covered calls and covered puts are another way to use options. These basically pay you for holding a cash position in the underlying. If you were in a long-term trade, you could earn additional return by selling a call option with a strike price at your profit objective and collect the premium. For example, say you are holding gold from $650 with a profit objective of $700. You could sell a $700 call option with six months until expiration for $1,100. This would bring a $200 a month average for doing so. On expiration the futures would need to be above $711 to represent foregone profits. If you are wrong on the underlying analysis, and the gold market falls, the losses are tempered by the premium collected.

There’s much more to options. Butterfly and condor, ratio call and put spreads, and their variations are extremely flexible. If you buy them they will greatly reduce the cost of getting long or short a market that has a high cost for the premium or time decay of their options.

There are many trade-offs between futures and options. When you understand how options work and know the right strategy for the given time frame and market situation, options can do more than just avoid some of the pitfalls in futures trading. They can increase your profits considerably.

Howard Tyllas is a 31-year veteran trader and is registered with the Commodity Futures Trading Commission as a floor broker and Commodity Trading Advisor. He has traded options on futures since their inception. His Web site is: www.howardtyllas.com.

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