An Option is an Investment Instrument That Brings Two Parties Together Into a Contractual Agreement.
The person who pays for the option has the right to follow through with the contract depending if they want to or not. Hence it is called an option because the owner of the option has the choice or “option” to carry out the agreement for a limited time. The person who sells the option and received the money for it is at the mercy of the buyer (unless they sell the option to someone else). The seller does not have a choice, but instead has an obligation and must follow through with the terms of the contract if the buyer chooses to do so. There are two types of options one is called a Call option and the other is a Put option. When buying a Call option you are bullish the market and want that particular commodity or futures to go up. The opposite is true for Put option buyers, they want the market to go down because they are bearish the market and will profit on a move to the downside.
Components of an Option
There are 6 main components that you need to know in order to understand how an option trade works. These components influence the original price of the trade and eventual outcome and need to be understood in order to use this investment tool correctly. In the following we will go over these components using a real estate option example and a commodity futures option example. I will use a real estate transaction as an example because it should be something everyone is familiar with. In fact, options are not only used in the commodity markets and the stock market, but are also commonly used in the real estate industry, too. We will use an example of a property that is currently being used as a farm but has potential for a better use. In the real estate example you will be buying one Call option for $5,000 that expires in 1 year with a strike price of $120,000 based on farm property that is currently valued at $100,000. In the commodity example we will use a December Gold $1,500 Call bought for $10.00 which is based on the December Gold Futures contract which is currently trading at $1,400 per ounce. For the following cases assume it is the beginning of September and of course in real trading there are commission costs that will have an impact on your results, but for the ease of explanation we will ignore commission costs in our examples.
|Dec Gold Futures
This is the number of options you want to buy. You can typically buy any number of options that you want depending on how much capital you want to risk on any one particular trade. The more options you buy the more money you can make on the trade, but it also means you will be putting more money at risk. If you buy 1 December Gold 1500 Call for $1,000 then the most you could loose is $1,000, if you buy ten of these options then you are risking $10,000 (10 options X $1,000 = $10,000).
Type of Option
There are two types of options: Call options and Put options. Simply said, when you buy a Call option you want the market to go up and when you buy a Put option you want the market to go down. We will get into specific examples of each later.
The underlying asset is the commodity or futures contract that can be bought or sold by the option holder. It is what the option is based upon, in our real estate example the underlying asset is the farmland. That is what the holder of the Call option can buy, nothing more or nothing less, if he or she so chooses. In our commodity example the December Gold futures contract is the underlying asset of the option. That is the market that we need to track and want to go up so we make money on our Call option. The size of the Gold contract is 100 ounces which is the fixed size set by the exchange. If you wanted to have a larger interest in Gold then you could buy more than one contract. If you bought 10 options you would own options based on a total of 1,000 ounces of Gold (10 contracts X 100 ounces each). You cannot buy contracts in any other size than is available at the exchanges, in other words, in Gold you could only have an interest in Gold in multiples of 100 ounces.
Underlying Asset Price
This is the price you want to move up or down in order to make your option’s value increase and make you money. In the real estate example the farmland is the underlying asset and it starts out being worth $100,000 when you buy the option. If you buy a Call option on this property you want the price of the property to increase as much as possible before your option expires. In the commodity example the underlying asset is December Gold which was trading at $1,400 per ounce. You would like to see this futures contract go as high as possible before the December Call option expires.
This is the component of the option in which we want to see the underlying asset’s price go towards. In the farmland example the strike price of the option is $120,000 while the current price of the land was only $100,000. Since it is a Call option we want the price of the property to go up towards $120,000 and then even higher. A Call option with a strike price that is higher than the current price of the underlying asset is called an “out-of-the-money” option. Just because an option is out-of-the-money does not mean you are not making money on that particular option, it is just an option that has not reached the strike price yet. In the commodity example the strike price is $1,500 per ounce and we bought the option when gold was at $1,400 per ounce so at that time it was an out-of-the-money option. Assume December Gold futures rally to $1550 before your option expires, you would now own an option that is called an “in-the-money” because the underlying price is through the strike price. In the case of Calls that means the commodity’s price is higher than the strike price and when looking at Puts, in-the-money means the price of the futures is lower than the strike price of the option. When you begin to trade you should be typically buying options that are initially out-of-the-money with hopes that some day before the option expires it will be through the strike price and become a profitable in-the-money-option. Remember that you do not have to wait until an option is in-the-money to sell it or to make money on it. If the market looks like it is not no longer moving in your direction and has not reached your strike price you may still sell it at the going market price.
The strike price’s proximity to the underlying asset’s price is an important relationship and has the most significant influence on the option’s price. For example, if the Gold futures market is at $1,400, a $1,450 Call will be more expensive than a $1,500 Call because it is more likely that Gold will hit $1,450 as compared to $1,500. You must also keep in mind though that since the $1,400 Call costs more if you are wrong you will lose more money on the $1,400 Call because it will have a higher premium. So there is a happy medium when choosing strike prices, you do not want to buy an option that is too far away because the market may never get there or if it does you will not make as much money. On the other side of the coin you do not want to buy too close of a strike price option because it will cost more and therefore you if you are wrong you risk losing more.
This is the date at which the option will stop trading and cease to exist and you must sell or exercise your option on or before this date. The expiration date of an option can be found by looking it up on our website here. Keep in mind you can sell your options any time (the market is open) before this date, as you do not have to wait until the expiration date to sell your option. Also, keep in mind that when you have a profitable trade you will be typically be selling your option for your profit instead of exercising it into a futures contract. This expiration date is what makes an option a time decaying asset, that means as time goes buy the option will lose its “time value.” All else being equal the more time an option has left, the more it is worth. If you bought a Call when the Gold market is at $1400 and a month later it is still at $1400 your option will lose some time value. So if you bought it at $10.00 and a month has gone by without the market moving in your favor your option will now be worth less, something like $7.00. This is because people will now be willing to pay less for an option that has one month of less time on it. If you do not sell your option and let it expire while it is in-the-money, then it will automatically turn into a futures position from the strike price, so if you do not want this to happen make sure you sell any in-the-money options before they expire.
The premium is the amount you pay for the option and this is your risk when you by an option because you cannot lose more than what you pay for any Put or Call option. This is the number that will directly determine if you are making or losing money on a trade. If you buy a Gold option for a premium of $10.00 then $1,000 is the most you can lose on that option. The objective is to sell this option before the expiration date for more than what you paid for it. Selling the option for anything above $10.00 would get you a profit, ignoring commission costs. One common mistake people believe is that the underlying asset’s price has to reach the strike price to make a profit and this is not necessarily true. In simple terms you need to sell the option for a higher premium than what you bought it for to make a profit. So, let’s say that you buy a December Gold $1,500 Call in September for $10.00 when the December Gold futures contract is trading at $1,400. The next day Gold rallies $20 to $1420 per ounce. What do you think happens to the premium of your Call option? It goes up, of course. Gold is now $20 closer to the strike price and only one day has past by so with very little time value lost, the option will now increase in value because the underlying Gold futures is now even closer to $1,500. A new approximate value of the option would be around $11.00 or a $100 profit so far ($1,100 – $1,000 = $100). This is because people are now more willing to pay more for a Call option that is closer to the underlying gold futures price of $1,420 as opposed to $1,400 the day before. If you changed your mind and thought $1,420 was as far as gold was going to go then you could sell your Call option for the $1,100 and take your $100 profit (ignoring commission) even though the Gold futures did not go to $1,500.
As you can see there are many pieces to the option puzzle that you need to fully understand before you trade options. Feel free to call us should you have any questions or do not understand any of the components explained above.