options primer - part 1
This is an excerpt from an email sent to a friend about getting started with trading options (from late May '06)...So here is the main idea: buying an option on a future allows you to limit your risk potential to the price you pay for the option. Buying a "call" option is like going "long" the futures market. Buying a "put" option is like going "short" the futures market. There are few variables associated with the valuation of the options. The two important variables are time and the "strike price." You'll hear the saying that there is a "time value" associated with an option. That means that the option only has value for a specified amount of time and after that time it is worthless, which is where the saying "most options expire worthless" comes from. The idea is to liquidate the option before expiration and get more back than what you paid.
The "strike price" is one of the terms of the contract you enter when buying an option. Say, for example, you believe the price of gold will go up to $1000 before the end of the year. The strike price for the option you're looking for would be $1000. That's not how much you have to pay for the option, it's just what you are predicting the value of the underlying commodity (in this case gold) will go up to before the end of the year. Right now since the December futures contract for gold is trading at about $670 per ounce (5/25/06), the probability of gold going to $1000 before the end of the year is relatively low. This probability is the factor which determines the price you actually pay for the option. The lower the probability that gold will reach $1000 by the end of the year, the lower the price will be for the option.
Like I said earlier, when you anticipate price appreciation of the underlying commodity, you purchase a "call" option. So the verbage goes like this: buy a December gold call option with a strike of $1000. Some people prefer a different order of the words, but the meaning is the same. The strike price is $1000, you are purchasing a call option, and the option is for the month of December. As I'm writing this email, the cost of purchasing this exact call option is $270. This price is determined, again, by the probability of the market approaching that price level in the specified time horizon. Now here's the really interesting part: the value of the future never has to actually reach the strike price ($1000 in this case), it just has to continue approaching it. The other variable is time. As the time window between now and December becomes smaller, so does the probability for the strike price being achieved.
I hope this has made sense so far. Here's an example of a trade I recently made.
On April 21 I purchased call options for June gold with a strike of $700. The price I paid for each of these options was $160. At the time I purchased them, I believe June gold was trading at around $600. The reason for the relatively low price of $160 is due to the fairly low probability of the June gold futures contract reaching $700 before the expiration of the call option. I purchased the calls because I believed there was a good chance gold would continue its rise. Gold did continue to rise... and at a very fast clip. Before long the price of gold was at $680 then $690 and, finally, $700. At that point in time, the value of each of the call options was $1700. I liquidated at that price on May 3 (I believe). In my opinion, the beauty of this approach to trading is twofold. First, you limit your maximum loss exposure to what you pay for the option at the beginning. In the case of my example, the price of $160 per call option is the maximum loss I could possibly be subjected two. Second, although you may not get the magnitude of return you can get with some futures trades, you can get a much higher percentage return with options. My net return for the gold trade was $1540 ($1700-$160) per option, which is not necessarily a difficult magnitude to achieve with futures, but the 963% return rate is very difficult to achieve with futures. Not only that, but with futures contracts you're subjected to potentially unlimited losses (which can obviously be minimized with the use of stops, but even then there's no guarantee of your exact exit point).
posted by jared @ 2:37 PM
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