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Learn How to Protect Your Assets While Generating Income with Options.

Options can provide traders with leveraging power, risk management, and potential for higher returns. But first you have to understand how they work. Our Introduction to Options Trading Guide provides: Basics of Options, What Causes Options Pricing Fluctuations, and Beginning Options Strategies.

Get your complimentary copy.

Hello again Fast Break readers. It's been my privilege through the years to provide you with some of my market analysis and educational features. And I am very pleased to be providing Fast Break issues on behalf of RJO Futures. In producing each report, it's my mission to ensure that you will take away at least one valuable trading "nugget" that will enhance your own trading methodology. In this educational feature, I will discuss trading options on futures.

I know that many beginning (and even veteran) traders think options trading is too complicated, and they don't have a clue about the vega, theta, delta and gamma pricing formulas -- or the strangles, straddles, butterflies and other such options trading methods. Well don't worry, I'm not going to get into those strategies in this column.

Entire books have been written on options and options-trading strategies, but I will only focus on a few basic, low-risk and limited-risk trading strategies for both beginning and veteran traders. I'll also briefly talk about using options to "hedge" winning trading positions in volatile markets. Again, you don't have to be a rocket scientist to employ simple options-trading strategies, but I do suggest that you read a book or two on options trading.

First, I am going to assume that readers know the definition of an option on a futures contract, and also the difference between a put option and a call option and "in the money" and "out of the money." (It's okay if you don't know the meaning of these terms. Just go to one of the big futures exchange Web sites for glossaries including options terms before reading this article.)

A while back there was a big run up in the price of crude oil. It certainly was tempting for many traders to short that market at those sharply higher price levels. However, remember that to successfully trade futures you not only have to be right on market direction, you also have to be correct on the timing of the market move. Furthermore, you can be right on market direction and very close to being right on timing the trade, but still lose your trading assets because of market volatility. In crude oil for example, a trader could have established a short position two days before the top in the market was in and still be stopped out and lose his trading assets -- because of the high volatility.

Purchasing options allows you to limit your financial risk and lets you ride out volatile market swings without the worry of increased margin calls.

Buying a put or a call that is "out of the money" is a relatively inexpensive way to wade into futures trading. The money the trader lays out to his broker for the option purchase is all the trader has to worry about losing -- no margin money and no margin calls. He can sleep well at night. And he is still trading futures, learning the business and honing his trading skills.

Here's another trading tactic to think about regarding purchasing options in volatile markets. A protective buy stop or sell stop when trading straight futures contracts does not assure you will get out of the market (filled) close to your stop. For example, weather markets in the grains and soybean complex futures can produce limit price moves -- sometimes for two or more sessions in a row. If you have a straight trading position on in soybeans, and the market moves against you by the limit (or multiple limits) your protective stop is virtually worthless. But if you had hedged your straight futures position with a cheap out-of-the-money option purchase, you have limited risk in a volatile market.

Let's say you are long soybeans at $9.50 in a highly volatile market. You initiated that trade on the long side, but then decided to purchase an $8.50 put option that limits your trading risk to $1.00 a bushel ($5,000 per contract) plus the price of the put option purchase. The trade-off here is that you are gaining peace of mind and losing some profit potential. But for many traders, that's well worth it. You can stay in the game to trade again another day, and won't get wiped out by limit price moves.

There are trade-offs in purchasing and trading options on futures, as opposed to trading straight futures. If you purchase "out-of-the-money" options, the market has to move in your favor for a period of time before your option becomes "in the money." During periods of high market volatility, the prices of options can and usually do increase substantially. Such has been the case the past several months.

One more thing: Anyone considering trading options on futures needs to check the open interest level on the particular "strike price" they are contemplating trading. Just like in straight futures trading, the more liquid (higher open interest) strike prices and options markets are usually more desirable to trade.

Selling (Writing) Options

There are old sayings in the futures industry that go something like this: "Eighty percent of all options on futures expire worthless." And "the only way to make money trading options on futures is to sell them -- not buy them." Neither one of these statements is accurate. This educational feature will focus on the advantages and disadvantages of selling (also called "writing") options on futures.

But before I discuss writing options on futures, let me first elaborate on the first "old saying" that 80% of options on futures expire worthless. While I have heard the saying many times through the years, I have seen very few credible statistics on the percentage of futures options that "expire worthless." Consider this: If a trader hedges his straight futures positions with options purchases, and those options do perform their function of limiting risk for a period of time, then those options have performed their intended function -- even though they might expire "worthless." Also, most speculative options buyers who make profits on trades do sell their options before they ever expire. Thus, I expect it would be very difficult to have accurate statistics on the number of futures options that are bought and sold that did not successfully fulfill their intended purpose.

A major appealing factor for speculative traders to sell (or write) options, as opposed to purchasing options, is that the odds are more favorable for producing a winning trade. What's the reason? If a trader is writing options, generally the market can move "against" the trader by a certain amount before the trader sees his option's strike price hit and he starts to lose money. Also, the option writer has "time decay" working in his favor -- meaning that the day the option is sold, its time premium starts to decay as the option moves toward expiration.

Now you might be thinking this options-writing stuff all sounds pretty easy, huh? Well, hold on just a minute! Remember that there are trade-offs in every aspect of trading futures. Here's the "rub" with selling options:

• The premium that traders collect for writing options is generally not nearly as much as the profits a trader would collect on a straight futures trade or a winning options purchase trade. For example, if a trader sells a call option on corn futures for 20 cents, that is his profit. But then he has to wait (or squirm might be a better way to put it) until the option expires to secure his profit. For many traders, pocketing just 20 cents ($1,000) profit on one corn contract is a great amount, so they may sell several contracts to make a bigger overall profit.
• When writing options (just like in straight futures trading) you cannot absolutely limit your risk of loss. Margin money is required by the broker.
• Finally, there is one more "old saying" regarding writing options on futures, which goes something like this: "A trader will make money and make money and make money writing options -- until that one time when an option sale will go against the seller. And that one options sale will then take back all the profits that were made on the previous winning options sales -- and then some."
  

Learn How to Protect Your Assets While Generating Income with Options.

Options can provide traders with leveraging power, risk management, and potential for higher returns. But first you have to understand how they work. Our Introduction to Options Trading Guide provides: Basics of Options, What Causes Options Pricing Fluctuations, and Beginning Options Strategies.

Get your complimentary copy.