Commodities
Options Frequently Asked Questions
If you have additional questions or would
prefer to speak to us personally, please
call us toll-free at (800)405-6109
and one of our representatives will gladly
asssist you. You may also email your questions
to info@firstamericanfutures.com
Question
1 - What is my maximum risk if I buy an
option?
Question
2 - Doesn't this make options a risky investment?
Question
3 - Why have options on futures become such
an increasingly popular investment?
Question
4 - What exactly is an option?
Question
5 - Other than "call" and "put", what terms
do I need to be familiar with?
Question
6 - How are profits realized in option investing?
Question
7 - As an example, suppose I buy an option
to purchase 100 ounces of gold at a strike
price of $300 an ounce and the price of
gold goes to $330 an ounce, what's my profit?
Question
9 - At the present time, what options can
be purchased?
Question
10 - How long is the life of an option?
Question
11 - When I buy an option, how is the premium
cost arrived at?
Question
12 - What major factors influence the premium
cost of a particular option?
Question
13 - Exactly how much does the price of
the commodity have to change in order for
me to realize a profit on the option?
Question
15 - But can't leverage work both ways,
against as well as for you?
Question
16 - Once I've bought an option, will there
be a continuing market for that option?
Question
17 - Suppose an option I've bought very
quickly becomes profitable. Do I have to
wait until the expiration date to sell it?
Question
18 - Can I sell an option even if it isn't
currently worthwhile to exercise?
Question
19 - Can I follow an option's current market
value on a regular basis?
Question
20 - How much should I know about the underlying
commodity in order to consider investing
in options?
Question
21 - When I purchase an option, who is the
party on the other side of the transaction?
Question
22 - Who assures payment on exchange-traded
options contracts?
Question
23 - What brokerage commissions are involved
in buying options?
Question
24 - What place do options have in an overall
investment program?
Question
25 - How do options compare with other investments
that involve similar risk and reward arithmetic?
Question
26 - Investment experts mention the "positioning"
advantage of options. What exactly do they
mean?
Question
1 - What is my maximum risk if I buy an
option?
The nature and amount of downside risk is
a good first question to ask about an investment
you may be considering. In the case of options,
the maximum risk is that you could potentially
lose the money known as the premium which
you invested to purchase that particular
option, plus the brokerage and transaction
costs involved in making the investment.
There can be no assurance any given option
will become worthwhile to sell or exercise.
Profitability depends on whether the price
movement you anticipate occurs during the
life of the option.
Question
2 - Doesn't this make options a risky investment?
It
makes options an inappropriate investment
for some people. This is why your broker
will ask you questions that may seem somewhat
persona1 about your financial situation
and objectives and will require that you
acknowledge reading and understanding a
Risk Disclosure Statement prepared by the
Commodity Futures Trading Commission. This
is important and should be considered in
deciding whether options are an appropriate
investment for you. Money needed for family
living, insurance protection and basic savings
programs obviously should never be committed
to any form of investment that involves
significant risk, regardless of the opportunity
for profit.
Question
3 - Why have options on futures become such
an increasingly popular investment?
Options
make it possible to realize a potentially
substantial profit, perhaps in a short period
of time, with a relatively small investment
and a known and limited risk. Under no circumstances
can the loss exceed the cost of purchasing
the option.
Question
4 - What exactly is an option?
There
is regulated exchange trading in two types
of options on futures contracts, known as
call options and put options. Which one
to consider investing in will depend entirely
on your price expectations. That is, on
whether you expect the price of particular
commodity to go up or whether you expect
it to go down.
Question
5 - Other than "call" and "put", what terms
do I need to be familiar with?
Just a couple. You should know what's meant
by an option's "premium" and by its "strike
price".
Premium
- Used in connection with options, premium
has the same meaning as when used in connection
with insurance. It's the price that you
pay to buy a given option. (See question
11 for an explanation of how option premiums
are determined).
Strike
Price - This is the specific dollars and
cents price at which the option gives you
the right to buy a particular commodity
in the case of a call or to sell the commodity
in the case of a put. The strike price is
stated in the option.
Throughout
this guide, "price" refers to the quoted
futures price of the commodity. Example:
If a call option gives you the right to
buy 100 ounces of gold at a price of $300
an ounce, $300 is the strike price. At any
given time, there is likely to be trading
in options with a number of different strike
prices. When you buy a call, you hope the
market price of the commodity (when the
option expires) will be above the option's
strike price by an amount greater than the
cost of the option, thereby causing the
option to become profitable. When you buy
a put, you hope that the market price of
the commodity will decline below the option's
strike price by an amount greater than the
cost of the option.
Question
6 - How are profits realized in option investing?
Generally
by instructing your broker to sell your
option rights to someone else (who may expect
them to further appreciate). The sale will
be accomplished on the trading floor of
the exchange (the same exchange where the
option was bought) and your net profit will
be the difference between the price that
you originally paid for the option and the
higher price that you are able to sell it
for, less brokerage and transaction expenses.
The mechanics are more complicated than,
for example, selling shares of common stock
that have appreciated.
An
alternative to selling a profitable option
is to exercise the option rights yourself.
Doing this, however, would result in your
actually acquiring a position in the futures
market which could require an additional
investment on your part and involve significantly
greater risks. Most investors therefore
prefer to realize their profits by simply
selling the option at its increased value.
Question
7 - As an example, suppose I buy an option
to purchase 100 ounces of gold at a strike
price of $300 an ounce and the price of
gold goes to $330 an ounce, what's my profit?
If gold climbs to $330 an ounce at expiration,
your call option will have a value of $3,000,
the $30 an ounce price increase, times 100
ounces. The profit will depend on what you
paid for the option to start with. If your
total costs (premium plus brokerage and
transaction costs) were, say, $700, then
your profit would be $2,300, the difference
between the $700 you paid for the option
and the $3,000 you can now sell it for.
As mentioned, the same broker who handled
the purchase can handle the sale. (Question
17 has more information about selling a
profitable option.)*
An
alternative to selling a profitable option
is to exercise the option rights yourself.
Doing this, however, would result in your
actually acquiring a position in the futures
market which could require an additional
investment on your part and involve significantly
greater risks. Most investors therefore
prefer to realize their profits by simply
selling the option at its increased value.
Question
9 - At the present time, what options can
be purchased?
The
list of exchange-traded options has grown
rapidly and now includes a broad range of
agricultural commodities, precious metals,
energy products, financial instruments,
and foreign currencies.
The following is a partial listing of commodities
by category.
Agricultural:
Corn, Pork Bellies, Cotton, Lumber, Wheat,
Cattle, Cocoa, Coffee, Soybeans, Sugar,
Hogs, and Orange Juice - These reflect basic
supply demand developments and may provide
a leading indicator of renewed inflation.
Metals:
Gold, Copper, and Silver - Prices often
rise sharply during periods of inflation
and decline during recessions. They can
be volatile in either direction in times
of economic uncertainty.
Energy
products: Crude Oil, Heating Oil,
Gasoline, and Natural Gas - As history has
shown, prices can move rapidly and substantially
in response to political and economic events.
Interest
rates: U.S. Treasury Bonds, U.S.
Treasury Notes, Municipal Bond Index., and
Eurodollars - Even relatively small changes
in interest rates can result in major changes
in the market value of fixed income investments.
Common
stock indexes: S & P 500 Index,
Dow Jones Industrial Average, NASDAQ 100
Index, NYSE Composite Index - Indexes reflect
increases and decreases in the overall market
value of common stocks.
Currencies:
British Pounds, German Deutschemark, Swiss
Franc, Japanese Yen, Canadian Dollars, and
the U.S. Dollar Index - Trade balances,
economic trends, and government policies
can influence the value of foreign currencies
in relation to the dollar.
Question
10 - How long is the life of an option?
There
is normally trading in options that have
different lengths of time remaining until
expiration, from less than a month, to twelve
or more months. The choice is yours. This
flexibility makes it possible to select
whichever option best coincides with when
you expect a given price movement to occur.
For
example: buying an option that expires in
September allows two more months for the
expected price change to take place than
buying an option that expires in July. Purchasing
a longer option increases the premium cost
of the option somewhat, (see question 12)
but as with most things in life, it's usually
best to allow at least a little extra time
for an expected event to occur! Don't hesitate
to seek your broker's assistance in deciding
how long an option it would be advisable
to consider purchasing.
Question
11 - When I buy an option, how is the premium
cost arrived at?
As
mentioned, the premium refers to the price
you pay to buy an option. It also refers
to the price you receive if and when you
subsequently sell the option. Like prices
on the trading floor of a stock exchange
or futures exchange, option premiums are
arrived at through open competition between
brokers representing buyers and sellers.
Option markets are thus quite literally
supply and demand marketplaces. Trading
is subject to the rules of the exchange
and is closely regulated by the Commodity
Futures Trading Commission (CFTC), federal
agency. Firms that deal in options are also
subject to CFTC regulation and to regulation
by National Futures Association, the industry's
congressionally-authorized self-regulatory
organization.
Question
12 - What major factors influence the premium
cost of a particular option?
There
are three...and two of them have already
been mentioned: the amount of time remaining
until expiration and the option's strike
price. A third variable is the volatility
of the markets.
Time
to expiration: All else being equal,
an option with more time until expiration
commands larger premium than an option with
less time until expiration. The longer option
provides more time for your price expectations
to be realized.
Strike
price: In the case of call options,
it stands to reason that the most valuable
options are those which convey the right
to buy at a low price. Thus, all else being
equal, a call option with a low strike price
costs more to purchase than a call option
with high strike price. It's just the opposite
for put options. The most valuable puts
are those that have a high strike price.
Volatility:
Again, all else being equal, option premiums
are usually higher when the markets are
volatile. Volatile markets are considered
more likely to produce the price movements
that can make options profitable to own.
Question
13 - Exactly how much does the price of
the commodity have to change in order for
me to realize a profit on the option?
Fortunately,
this important calculation is also a simple
calculation, a matter of addition or subtraction,
depending on whether you are buying a call
option or a put option. The only two factors
involved are the cost of the option and
the option's strike price.
Calls
- To realize a profit on a call at expiration
the market price of the commodity must move
above the option strike price by an amount
greater than your costs (costs include the
premium invested to buy the option, brokerage
commission and any other applicable transaction
costs).
Puts
- To realize a profit on a put at expiration
the market price of the commodity must decline
below the option strike price by an amount
greater than your costs.
Question
15 - But can't leverage work both ways,
against as well as for you?
That's
true, the potential for a high percentage
return on your investment should be weighed
against the risk that if the option does
not become worthwhile to sell or exercise
by expiration you would lose your entire
investment in that particular option. Even
so, buying an option can involve much less
dollar risk than the alternative of owning
the actual commodity.
Example:
At the same time you spent $700 to buy a
100-ounce gold call option with a strike
price of $300, your wealthy neighbor, also
expecting an increase in the price of gold,
plunked down $30,000 to purchase 100 ounces
of gold bullion. If the price of gold unexpectedly
drops to, say, $270 at expiration, your
option will be worthless and you'll have
lost $700, 100% of your investment. Your
neighbor, if he decides to sell the bullion,
will incur only a 10% loss, but he will
be out $3,000...compared with your $700
loss.
Question
16 - Once I've bought an option, will there
be a continuing market for that option?
There's
generally an active market in outstanding
options right up to the day of expiration.
However, if an option is no longer deemed
to have much, if any, chance of ever becoming
worthwhile to exercise, there may not currently
be any market for it.
Question
17 - Suppose an option I've bought very
quickly becomes profitable. Do I have to
wait until the expiration date to sell it?
Absolutely not. When to sell such an option
is entirely up to you. On the one hand,
continuing to hold the option until nearer
its expiration date could result in your
realizing an even larger profit. But on
the other hand, an unexpected adverse price
movement could result in a reduction in
the value of the option. Deciding when to
sell a profitable option is thus a "bird-in-the-hand"
type of decision.
A
somewhat technical point to bear in mind
in making the decision is that in addition
to whatever amount, if anything, that a
given option would be worth to exercise,
options that haven't yet expired normally
also have what's called "time value".
Specifically,
time value is whatever amount other investors
are willing to pay you for giving up your
option rights prior to expiration. As you'd
expect, time value generally declines as
the expiration date approaches. It is also
influenced, prior to expiration, by futures
price movements and market volatility.
Question
18 - Can I sell an option even if it isn't
currently worthwhile to exercise?
The
answer is yes, if the option still has time
remaining until expiration, and if there
is still active trading in that particular
option. Whether the sale results in profit
or a loss will depend – as with any option
– on whether you sell it for more or for
less than you paid for it.
A
favorable change in the price outlook or
an increase in market volatility can make
an option suddenly more attractive to other
investors. If this results in an increase
in its premium value, you may be able to
sell the option at a profit even though
it isn't yet (and may never become) worthwhile
to exercise.
In
other situations, if prices so far haven't
moved the way you thought they would, and
if you no longer want to own the option,
selling it prior to expiration can provide
a way to recover some part of your initial
investment. Such a decision should not be
made hastily, however. The fact that you
have until expiration for your original
price expectations to be realized can give
you greater "staying power" than other investors
may enjoy.
It
is this 'staying power' – the ability to
weather what may prove to be only a temporary
price setback – that is one of the principal
advantages of investing in options. No matter
how large the adverse price movement, your
maximum loss is still limited to the cost
of the option.
Question
19 - Can I follow an option's current market
value on a regular basis?
Yes,
very easily. Options on futures contracts
are traded on regulated exchanges that have
continuous electronic quotation systems.
Business periodicals such as the Wall Street
Journal and many major newspapers report
actively traded futures prices and option
premiums daily. You can also phone your
broker who has computer access to current
option premiums (or explore sources for
direct online price reports). Being able
to know at all times what your investment
is worth is another attractive feature of
exchange-traded options.
Question
20 - How much should I know about the underlying
commodity in order to consider investing
in options?
The
reason for buying an option is because you
have an opinion about the probable price
movement of a particular commodity. The
opinion can be derived from your own knowledge
or, as is the case with most investors,
by dealing with a brokerage firm in whose
research and analytical abilities you have
confidence.
Question
21 - When I purchase an option, who is the
party on the other side of the transaction?
More
than likely, it's someone who engages in
a highly speculative area of investment
activity known as option "writing". Such
investors are also sometimes called option
"grantors". They stand to make money if
– and only if – your option rights at expiration
are worth less than you paid for them. In
contrast to the limited risk that's involved
in buying options, writing options involves
potentially unlimiited risks and is inappropriate
for most people. Do not consider it without
thoroughly discussing the costs and substantial
risks with your broker.
Question
22 - Who assures payment on exchange-traded
options contracts?
When
an option that you've purchase becomes profitable,
the funds needed to pay you are collected
(from the option writer on the other side
of the transaction) on a daily basis. This
is accomplished through the brokerage firms
and the clearing organizations of the exchanges
where options are traded.
Question
23 - What brokerage commissions are involved
in buying options?
Brokerage
firms differ in the services they provide,
in their success in helping clients identify
potentially profitable investment opportunities,
and in the commissions that they charge.
Provided commissions are stated in a clear
and forthright manner, each firm can set
its own rates – the same as firms in the
securities industry do. Nevertheless, commissions
are one variable in an option's profit equation
and you should be satisfied that they are
fair and reasonable in relation to the services
and advice being provided.
Question
24 - What place do options have in an overall
investment program?
To
start with, it should be said again that
options have no place at all unless some
portion of your total investment capital
can legitimately be considered risk capital
– money you can afford to take calculated
risks with in pursuit of a correspondingly
larger profit potential. If that requirement
is met, options might very well have a worthwhile
place in your total investment program.
While options aren't for everyone, a study
by John Lintner, PhD., of Harvard University
found that including futures investments
in a diversified stock and bond portfolio
had the overall result of "reducing volatility
while increasing return".
Question
25 - How do options compare with other investments
that involve similar risk and reward arithmetic?
Obviously,
no two or more investments have exactly
the same risk-reward characteristics. One
characteristic of options is that, to be
profitable, the anticipated price movement
has to occur within the time frame of the
particular option you've selected. Having
said this, however, options have a number
of distinct advantages in addition to their
limited risk. These include:
The
opportunity to profit whether the price
of a given commodity is expected to go up
(by buying calls) or go down (by buying
puts). This advantageshould be readily apparent
to investors who have had recent and frequent
reminders that prices in a dynamic economy
can move sharply downward as well as sharply
upward. Option profits can be re lized in
both market environments. Indeed, as easily
in one as in the other.
Diversification.
Because of the leverage options provide,
a given sum of investment capital can more
readily be divided among a number of different
market sectors simultaneously – such as
oil, metals, crops, and interest rates.
This diversification can improve your likelihood
of "being in the right places at the right
time."
Options
may be the least expensive way to acquire
an interest in just about any of the commodities
on which options are available. For example,
buying call options in anticipation of rising
energy or livestock prices may be considerably
less costly than the alternative of, say,
purchasing an interest in oil wells or a
cattle feedlot.
Question
26 - Investment experts mention the "positioning"
advantage of options. What exactly do they
mean?
This
question is of key importance, due to the
well-known fact that major price movements...the
kind that can make options especially profitable
to own...frequently occur in response to
specific economic or political events, that
may be anticipated but that can't be predicted
with absolute certainty. Yet once these
events do occur, there may be little or
no opportunity for small investors to participate
in the resulting price movement.
Examples:
A decision yea or nay by the Federal Reserve
on some important issue can have a sudden
and dramatic impact on interest rates, gold,
the stock market, and currency values. An
action by oil ministers or an escalation
of hostilities can send oil prices soaring
or nosediving. An announcement of new trade
rules can trigger a sharp movement in prices
of agricultural commodities. A principal
attraction of options some say the principal
attraction is that they provide a way to
"position" yourself to profit on a highly
leveraged, ground-floor basis if and when
the anticipated events and price movements
occur. And to do so with the knowledge that
the most you can lose if you are wrong is
the cost of an option.
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