Options Trading Tutorial

Options Trading Tutorial: Learn How to Trade Options

To completely understand the following tutorial to options, we are assuming you have read our futures trading tutorial.

For individuals seeking a less volatile investment, trading options on futures is the vehicle for them.

There are two different types of options: call options, and put options. Call options are purchased when you believe the price of the underlying commodity will rise, and put options are purchased when you believe the price of the underlying commodity will fall. When purchasing options, your maximum risk is the options premium. Premium, simply stated, is the price you pay for the option. Purchasing an option gives you the right to either buy (call) or sell (put) a certain commodity at a certain strike price. Strike price, is the price at which the option gives you the right to buy or sell. At any given time there are various strike prices available to trade on an underlying commodity.

For example: If you purchase a call option for Gold (contract size = 100 oz) with a strike price of $850, you have the right to purchase 100 oz of Gold at a price of $850/oz. If you were to purchase this option for $2,000, at expiration you want the price of Gold to be above $850 by an amount greater than the premium in order to be profitable. From our futures trading tutorial we know how to calculate this amount: tick size for Gold is $0.10, and each tick represents $10. Thus, we need gold to move up $20 above our strike price to be equivalent to $2,000. Our breakeven point for this scenario would be for Gold to be at $870/oz at expiration. Inversely, had we purchased a put option with a strike price of $850 for $2,000, we would need the price of Gold to be $830 to breakeven.

Options are comprised of two separate values: intrinsic value, and time value. Intrinsic value is calculated based on how close the current commodity price is in relation to your strike price. The closer your strike price is to the current market price, the more valuable the option. Time value is calculated based on how close you are to expiration. The further you are from expiration, the more time you have, thus the more valuable the option. There is an algorithm the exchanges use to couple both intrinsic and time value, to generate the options premium. Every option has an expiration date, and depending on your position you do not need to worry about the day to day fluctuations of a market, but rather the overall trend within the time you have purchased. For this very reason, investors are attracted to trading options over futures. Needless to say, options weigh the additional risk of losing time value at an exponential rate going into expiration. If we were trading futures, a one day move against our position may require us to liquidate due to a margin call, whereas with options we are able to sustain our position because we have purchased time for the underlying commodity to move towards our projected price.

So what have we learned?

There are two different types of options: Calls and Puts.
The price you pay for an option is called the Premium.
The strike price is the specific value at which you have the right to buy or sell.
Options are comprised of two values: Intrinsic, and Time.
If the current price of Gold is $800. A call option with a strike price of $810 would have a higher intrinsic value than a call option with a strike price of $850.
As we begin to near the expiration of an option, the time value of the option decreases.

So now that we have a basic understanding of how to buy options. Lets discuss how we can realize profits from trading options. Once you have purchased an option:

You will have the ability to resell that option at a greater or lesser value before expiration.
You will be able to exercise an option that is 'in-the-money' upon expiration, and enter a net long or short position in the underlying commodity.
Or you can let the option value diminish to near $0 if the market hasn't surpassed your strike price and time nears expiration.

Lets look into these three different scenarios with a hypothetical example. Lets say the current month is January, and the price of April Gold is $800/oz. Lets look at two call options: an April Gold Call with a strike of $800, and one with a strike of $825. The $800 call is valued at $8,000, and the $825 call is valued at $3,000.
Lets say you purchased the $825 call. Now let's assume within two weeks time the price of April Gold has risen to $825. How much have we profited from this move? We know that since the commodity price has risen closer to our strike price, our intrinsic value has increased, and we also know that we have lost two weeks of time value. In relation to time value, we technically have 4 months until expiration, and two weeks out of four months isn't too great of a loss. In relation to intrinsic value, we know that the initial $800 call option we looked at was valued at $8,000 when it was 'at-the-money' (meaning the strike price and current market price were equal). So now that the current market price of April Gold has reached the same value of our strike price at $825, we can make the assumption that the value of our option is roughly $8,000 minus the two weeks worth of time value. The exchanges use an algorithm to calculate this value, yet we can only make an assumption at the value. So within two weeks time we have made a profit of $5,000 minus the two weeks time value we lost. We can enter an order to offset our position to realize profits. Progressively, if it took two months to reach $825, we would make an assumption that maybe the amount gained in intrinsic value has been offset by the amount of time value we have lost, and our trade might be even. Furthermore, if it takes four months to reach $825, we can be pretty certain that the value of the option is near $0 due to the fact that there simply isn't anymore time left.
Now lets continue with the preceding example, and say upon expiration the price of April Gold is now $900/oz. We have realized a profit of (900-825) $75/oz per 100 ounces. $7,500 minus our initial $3,000 investment leaves us with a net profit of $4,500. Prior to expiration, we can offset this position to lock in profits. Or we can leave the position into expiration, at which point we would be assigned a net long position in April Gold futures. Keep in mind, since we purchased a call option, we are assigned a long position. Had we purchased a put option, we would be assigned a short position if the price had decreased and we were 'in-the-money'(meaning the market price had surpassed our target strike price). Now that we have been assigned a futures position, we must be aware of the additional margin requirement needed to hold onto such a position. We would be assigned a net long position at $825 when the market price is $900, and we can continue to ride the futures position.
*Note: all examples used did not account for commission and brokerage fees. Costs are associated with all transactions, and should be accounted for.
Selling Options, also known as 'writing' options is a way to profit by predicting where a market will not go. Some individuals assume it is a lot easier to make this type of prediction, in addition to the various strategies available to lower your risk when writing options.

To learn more about selling options, feel free to contact any one of our qualified brokers and we will be happy to provide you with further information.

Need more information before you sign up for your futures trading account?

* The information provided here is purely educational, Expo Futures will not be held responsible for either its accuracy or completeness. There is a risk of loss in trading options. Trading options is not suitable for everyone. Past performance is not indicative of future results.