INVESTORS Q & A
An Introduction to Their Uses and Risks
A Guide to Uses and RisksAnswers to frequently asked questions about buying options on futures as an investment.
Approximately 100 million options, encompassing a wide variety of basic commodities and financial products, are traded annually on the nation's regulated exchanges. This guide has been prepared to provide answers to frequenly asked questions about purchasing options as an investment. Hopefully, they will be helpful in deciding how much of your portfolio should be invested.
1. What is my maximum risk if I buy an option?
2. Doesn't this make options a risky investment?
3. Why have options on futures become such an increasingly popular investment?
4. What exactly is an option?
5. Other than "call" and "put", what terms do I need to be familiar with?
6. How are profits realized in option investing?
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 goes to $330 an ounce, what's my profit?
8. How large is my profit potential when I buy an option?
9. At the present time, what options can be purchased?
10. How long is the life of an option?
11. When I buy an option, how is the premium cost arrived at?
12. What major factors influence the premium cost of a particular option?
13. Exactly how much does the price of the commodity have to change in order for me to realize a profit on the option?
14. It's often said a major advantage of options is "leverage". What does this mean?
15. But can't leverage work both ways, against as well as for you?
16. Once I've bought an option, will there be a continuing market for that option?
17. Suppose an option I've bought very quickly becomes profitable. Do I have to wait until the expiration date to sell it?
18. Can I sell an option even if it isn't currently worthwhile to exercise?
19. Can I follow an option's current market value on a regular basis?
20. How much should I know about the underlying commodity in order to consider investing in options?
21. When I purchase an option, who is the party on the other side of the transaction?
22. Who assures payment on exchange-traded options contracts?
23. What brokerage commissions are involved in buying options?
24. What place do options have in an overall investment program?
25. How do options compare with other investments that involve similar risk and reward arithmetic?
26. Investment experts mention the "positioning" advantage of options. What exactly do they mean?
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.
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.
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. Back to top
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.
Call option
Purchasing a call gives you specific locked-in price at which you have the right, but not the obligation, to buy a futures contract on a commodity that you expect to increase in value. Thus, if you look for, say, the price of gold to go up, you'd buy a gold call option.Put option
Purchasing a put gives you a specific locked-in price at which you have the right, but not the obligation, to sell a futures contract on a commodity that you expect to decrease in value. Thus, if you look for the price of gold to go down, you'd buy a gold put option.One easy way to remember which is which is to think of the terms "call up" and "put down". A call is a way to profit if prices go up. A put is a way to profit if prices go down. If and when the market price of the commodity moves in the direction you anticipated, this will be reflected on a day-by-day basis in the value of your option rights (Throughout this guide, "price" refers to the quoted futures price of the commodity). The more valuable your option rights become, over and above what you paid for them, the larger your profit will be when you decide to sell or exercise the option.
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 document prepared by the Commodity Futures Trading Commission. 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. Back to top
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. Back to top
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. Back to top
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.)*Gold Futures/Option Value Option Gross Profit/Loss
• $300 or less $0 $700 700 Loss
• 305 500 700 200 loss
• 307 700 700 Break even
• 310 1,000 700 300 profit
• 320 2,000 700 1,300 profit
• 330 3,000 700 2,300 profit
* Illustration of profit or loss on 100-ounce gold call option if option strike price is $300 an ounce and the cost of purchasing the option was $700 ($7 an ounce)
8. How large is my profit potential when I buy an option?
There is no limit on the potential for profit. The greater the price movement, provided it's in the direction you anticipated and provided it occurs during the life of the option, the larger the profit. As previously indicated, it is this combination of limited risk and unlimited profit potential that is a principal attraction of options as an investment vehicle. Back to top
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.
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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.
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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.
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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.
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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.
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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.Back to top
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.
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. Back to top
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.
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).Example:
In anticipation of rising prices, you invest $700 (the equivalent of $7 an ounce) to buy a 100-ounce gold call option with a strike price of $300 an ounce. For the option to become profitable at expiration, the price of gold must climb above $307. For each $1 an ounce it increases above that amount, your profit is $100.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.Example:
In anticipation of declining prices, you invest $700 (the equivalent of $7 an ounce) to buy a 100-ounce gold put option with a strike price of $300 an ounce. For the option to become profitable at expiration, the price of gold must decline below $293. For each $1 an ounce it declines below that amount, your profit is $100. Back to top
14. It's often said a major advantage of options is "leverage". What does this mean?
Greater leverage, which options provide, means that even a small favorable movement in the underlying commodity price, can yield a high percentage rate of return on your investment.Example:
You've invested $700 to buy a three-month gold call option with a strike price of $300 and the price of gold has climbed to $328. The option that cost only $700 can now be sold for $2,800, a net profit of 2,100 in three months. Stated another way, it took less than a 10% increase in the price of gold (from $300 to $328) to give you a 300% return on your $700 investment. That's leverage.
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.
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.
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. Back to topA 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.
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. Back to top
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.
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.
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. Back to top
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.
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.
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". Back to top
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. Back to top
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. Back to top
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" Futures and options trading involve risk of loss and may not be suitable for everyone." | © 2004 United Strategic Investors Group, Inc. All rights reserved