Options Overview and Trading Techniques

By Matt Krupski of Lind-Waldock

If you are new to options, you'll find they open up an exciting new realm of investment opportunities for you. Options can be used alone or in conjunction with other market positions for a variety of strategies, including portfolio protection, risk management, speculation, to generate potential income, and to enhance returns. Options can be complex and confusing, so hopefully I can help remove some of the mystery.

Options Terminology

There are two types of standard options: puts and calls. Call options represent the right to buy the underlying contract at a specified price (strike price) any time before a specified date. Put options represent the right to sell the underlying contract at a specified price (strike price) any time before a specified date.

While there are two basic types of options (puts and calls) there are also different styles of options depending on the product traded, with different expiration procedures. American Style options can be exercised at any time before the expiration date of the option. European Style options can only be exercised at the expiration of the option contract.

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In most cases, the style of the option is irrelevant to the average trader, because options are tradable contacts. Both American Style and European Style options trade at U.S. exchanges. The type can vary by product. In either case, exchange-listed options are standardized contracts that can be bought and sold among different parties. Therefore, the holder (buyer) of an option can sell his/her contract to another party to offset the position anytime prior to expiration, thus realizing a profit or offsetting a loss, and eliminating the position from his or her books. Similarly, if one has a short options position, it can be bought back at any time before expiration. And actually, in some cases it makes more sense financially to trade out of your options position, rather than exercise it before the expiration date, especially if there is a lot of time until expiration.

Let's now define some basic options terms and concepts I will discuss further.

Premium - The cost of the option contract itself.

Strike Price - The price at which you can take a position in the underlying contract.

Underlying - The futures contract that the option is based on (i.e. March crude oil futures, December corn futures, June S&P futures, etc).

Exercise - The act of exchanging the option for a position in the underlying futures. contract. The holder of an option exercises his right to buy (in the case of calls) or sell (in the case of puts) the underlying future at the strike price.

At the Money - If an option is at the money, the option's strike price is the same as the underlying price. For example, if March crude futures are trading at $51, the March crude 51 puts and March crude 51 calls are both “at the money.”

Out of the Money - If the option is out of the money, the option's strike price is higher (for calls) or lower (for puts) than the underlying price. For example, if March crude futures are trading at $51, the March crude 55 calls and 48 puts are both “out of the money.”

In the Money - If the option is in the money, the strike price is lower (for calls) or higher (for puts) than the underlying price. For example, if March crude is trading at $51, the March crude 55 puts and 48 calls are both in the money. In-the-money options have intrinsic value, because they could be exercised, and the resulting futures position immediately offset in the futures market for profit.

Characteristics of Long Call Position

If you are long calls, the maximum profit potential is unlimited. For example, if you buy a 55 crude oil call, you have the right to be long futures from $55 no matter how high crude goes. There is also no margin requirement, and your risk is defined. The most you can lose is the premium paid for the option, plus commissions and fees. So if crude futures are below the strike price at expiration, the option simply expires worthless and you do not exercise your right.

Long calls also give you leverage. For your 55 call, you are paying $1,750 for the right to control 1,000 barrels of crude oil. At a strike price of $55 per barrel, this represents $55,000 worth of crude.

However, time works against you. Each day that passes, the option loses a little bit of time value.

Characteristics of a Long Put Position

When you are long puts, you are anticipating the underlying market will decline. Your maximum profit potential is virtually unlimited. For example, if you buy a 48 crude oil put, you have the right to be short futures from $48 no matter how low crude goes. Your profit is only maxed out if the crude futures go to zero. There is also no margin requirement, and your risk is defined. The most you would lose is the premium paid, plus commissions and fees. If crude rallies, or finishes above the strike price at expiration, the option simply expires worthless and you do not exercise your right to the underlying position.

You also have added leverage with a long put. For your 48 put, you are paying $1,000 for the right to control 1,000 barrels of crude. At a strike price of $48 a barrel, this represents $48,000 worth of crude. However, time works against you. Each day that passes the option loses a little bit of time value.

Options Strategy #1: Portfolio Protection

I will go through some examples of how options can be used for portfolio protection, that is, as a risk-control tool against another market position. Please keep in mind, the prices and dollar amounts quoted are for example purposes only, and may not reflect current conditions. These are also not to be construed as specific trade recommendations.

Example: Buying Puts to Protect a Long Futures Position

Say you are long one March crude futures contract from $51.50, and are therefore exposed to downside risk. To help protect (or hedge) your portfolio, you buy one March crude 50 put for $2 (at a cost of $2,000 before commissions/fees).

You now have the right (but not the obligation) to sell one March futures contract at $50, thereby limiting your risk to $1.50 on the futures contract, plus the $2 premium paid for the option (before commissions/fees). No matter how low the futures contract falls, as an options holder, you can sell one futures contract at $50 if you wish.

In buying a put in lieu of using a stop-loss order in the futures contract as a risk-management tool, you have protected yourself against possible “whipsaw” action that could take you out of your position.

Example: Buying Calls to Protect a Short Futures Position

In this example, you are short one March Treasury bond futures contract from 111-00, and are therefore exposed to upside risk. To help protect your portfolio, you decide to buy one March bond 112 call for 29/64 (at a cost of $453.13 before commissions/fees).

You now have the right (but not the obligation) to buy one March bond futures contract at 112-00, thereby limiting your risk to $1.00 on the futures contract plus the 29/64 premium paid for the option (before commissions/fees). No matter what the underlying contract does, you can buy one futures contract at 112-00.

Options Strategy #2: Long Options for Speculation/Leverage

Options can also be used for speculation purposes, with or without any other positions. If you are bullish on a particular market, you can buy an options contract to establish a bias. Buying calls would establish a long bias, in the hope that if the underlying market rises, the call contract (or right to buy) will increase in value as well.

Or if you are bearish, buying puts would establish a short bias in the hope that if the underlying market falls, the put contract (or right to sell) will increase in value as well.

Options Pricing

So what determines an option's value? In general, it's the perceived probability of it finishing in the money. The basic fundamental forces of supply and demand still hold, however; the contract is worth whatever someone will pay for it.

What determines the premium? The more time there is until expiration, the greater the chance that the option could finish in the money. Therefore, the price of the option will be higher. You have more time to be right, so to speak, so you pay more for that right.

The relationship of the strike price to the underlying is also an important factor in options pricing. For example, if crude oil futures are trading at $50, the right to buy crude at $55 is worth more than the right to buy crude at $60, because the chance of crude finishing above $55 is greater than the chance of it finishing above $60 at expiration. It would have to make a much larger move ($10 versus $5) in the same timeframe, to get to $60.

Volatility is also an important factor related to options pricing. As market participants anticipate large price swings, the chances of an option finishing in the money theoretically goes up, as will its value. Note that this is anticipated volatility; we are interested in what the underlying will do between now and expiration, not what happened in the past.

Options Strategy #3: Long Calls for Speculation

Let's go over another example using long calls for speculation, and how to determine which calls to use with these pricing tenets in mind. Say March crude oil is trading at $52, and you believe the price will go up. So, you consider buying either the March crude 52 calls or the March crude 55 calls.

The March crude 52 calls (at the money) are trading at $2.90

The March crude 55 calls (out of the money) are trading at $1.75

Note that the at-the-money calls are more expensive than the out-of-the-money calls. The right to buy crude at $52 is more expensive than at $55, because there is a greater chance crude will rise above $52 than above $55 before expiration. Think of it this way: if they were priced the same, then why would anyone buy the $55 call?

For the sake of example, you decide you don't want to pay for the higher-priced option, and buy one March crude 55 call at $1.75 ($1,750 before commissions and fees). You now have the right (but not the obligation) to buy one March crude futures contract at $55 before the option expires (in this example, on February 14). In exchange for this right, you would pay $1,750, plus commissions and fees.

Tables 1 and 2 illustrate how various options values change based on the underlying market's price, and how your potential profit or loss would be impacted.

Table 1: Profit/Loss at Expiration (Exclusive of Commissions)

Table 2: Long Crude 55 Call for $1.75

Options Value

The value of the option is the intrinsic value plus the time value. Because the option in this case is out of the money, its intrinsic value is zero (all of its value is time value). With each day that passes, the time value drops, until expiration, when the time value is zero. As the price of the underlying market moves, the value of the option changes. The amount the value of the option changes in relation to the movement of the underlying is known as its delta.

As time passes, the option's value approaches pure intrinsic value. Table 3 illustrates this concept.

Table 3: Approximate Option Value

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Options Strategy #4: Long Puts for Speculation

Let's now look at using long puts for speculation. The price of March crude oil futures are trading at $52. You believe the price of crude will fall, so you consider buying either the March crude 52 puts, or the March crude 48 puts.

The March crude 52 puts (at the money) are trading at $2.90

The March crude 48 puts (out of the money) are trading at $1.00

You decide you want the cheaper option, buy one March crude 48 put and pay $1 ($1,000 before commissions and fees). You now have the right (but not the obligation) to sell one March crude futures contract at $48 before the option expires (in this case, on February 14). In exchange for this right, you pay $1,000, plus any commissions and fees. Tables 4 and 5 illustrate this scenario.

Table 4: Profit/Loss at Expiration

Table 5: Long Crude 48 Put for $1.00

Options Strategy #5: Using Options to Generate Income

There are options strategies that can be used as potential income-generating tools. I'll discuss one of these, selling (writing) a call against a long futures position (covered call).

Example: Covered Call

Say you are long a March futures contract from $52. You sell one March crude $55 call at $1.75, and collect the premium ($1,750 before commissions and fees). You are now obligated to sell one crude futures contract at $55 to the holder (buyer) of the option if the holder exercises his or her right to the underlying. In turn, you keep the premium, whether or not the option is exercised.

Let's look at some scenarios at expiration based on this strategy. With the price of the crude oil futures trading above the option's strike price, the option holder exercises his or her option, and forces you to sell one futures contract at $55. This offsets your long futures position. You keep the premium of $1,750, and realize $3,000 on the futures (long from $52 and offset at $55). Your profit is capped at $4,750 at expiration, less commissions and fees.

Now, let's say the price of crude oil futures are trading below the strike price. The option expires worthless. You keep the premium of $1,750, and your profit on the futures is determined by where you offset in the market, less commissions and fees.

Tables 6 and 7 show various profit and loss scenarios based on this scenario, and how the change in the price of crude oil futures impacts your outcome. The blue line in Table 7 represents the profit or loss for an uncovered futures position, while the pink line represents the profit or loss for a long futures position combined with a short 55 call. In the covered call scenario, you can see that your profit potential is capped, but the trade off is that you can get additional income from selling the call, as reflected in the upward shift of the pink line (long futures, short call) from the blue line (long futures only).

Table 6: Long Crude Futures from $52, Short $55 Call at $1.75 at Expiration

Table 7: Profit and Loss at Expiration

A covered put situation is similar to the covered call scenario, with the difference being that your risk is to the upside, rather than the downside. In a covered put, you would sell a futures contract and sell a put. The buyer of the put would have the right to sell you a futures contract at the strike price of the put, obligating you to buy one futures contract if that individual chooses to exercise the option. Your profit potential on the short futures position would be capped as futures move below the strike price of the put you sold. You would collect the premium from selling the option no matter what price the contract finished at. Your upside risk is still unlimited on the short futures position.

I've just covered some of the basic concepts about options that I feel new options traders should know, but I've really just scratched the surface. There is a lot more to learn about options, including other strategies such as naked options, straddles and strangles. I invite you to explore the world of options further, and to contact me with any questions you might have about futures or options trading, or the markets.

Matt Krupski is a Senior Market Strategist with Lind Plus. You can reach him at 877-847-3034 or via email at mkrupski@lind-waldock.com if you have questions on this topic, or to discuss specific trading strategies for your unique situation.

Matt Krupski
Years Trading: 7
Favorite Movie: Caddyshack

Matt Krupski is a Senior Market Strategist with Lind Plus, Lind-Waldock's broker-assisted division. He got his start working in the index option pits of the Chicago Mercantile Exchange and Chicago Board of Options Exchange as an arbitrage clerk and market maker for a proprietary market-making firm.

After market hours, he taught classes on option strategies and valuation to arbitrage clerks and junior traders. After leaving the floor, Matt traded single-stock futures and index futures off the floor at the Chicago Board of Trade for a proprietary trading group. His goal as a Lind Plus Market Strategiest is to help clients preserve and increase their capital through defined strategies tailored to their individual appetite for risk. He concentrates on utilizing both long and short option strategies, spreading futures, trailing stops, and monitoring technical support and resistance levels to help clients achieve their goals.

He can be reached at 877-847-3034 or via email at mkrupski@lind-waldock.com.

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