Preparing For Trading Options
People interested in trading options may be talking about trading stock options or trading options on futures contracts
. But the concepts underlying these types of financial trades are the same. An option is simply a right, but not an obligation, to buy or sell some sort of financial product. The financial product may be a stock or it may be a contract that has an underlying asset that is being bought and sold in the marketplace. The future contract itself is an obligation that is placed on the buyer and the seller like any other contract, but when trading options on futures contracts you are talking about the buying and selling of the futures contract and not the commodity.When comparing stock options to options on futures contracts, there are some similarities and there are some differences. A stock option represents a contract to buy 100 shares of stock that serves as the underlying instrument. An option on a futures contract represents one futures contract that also gets its value from the price of the underlying instrument which are non-equity assets like commodities.
Options for both stocks and futures contracts must outline the specifics of the transaction which includes naming the underlying commodity or equity, delivery and price among others. Both types of options also have calls and puts which indicate the equivalent of bets on whether the price of the underlying asset will rise or fall. A call option means you expect the price to go up. A put option means you expect the price to go down.
Both types of options also have a premium attached. The futures contract itself does not have a premium, but the options on the futures contract does. The term premium refers to an amount a buyer pays a seller for gaining the privilege of not having to buy the underlying asset in the event the price movements are not beneficial to the buyer. It is the most a buyer can lose on a contract no matter what the price of the asset does in the marketplace because the buyer can choose to not exercise the right on a losing transaction.
Learning About Volatility
The amount of volatility in options refers to price action. Volatility addresses the propensity of the price of the underlying security to go up or down in the marketplace. In a nutshell, there is a relationship between the market conditions that affect the volatility of an asset and the volatility of the option itself but that relationship may not be an exact correlation.
Estimating the possible price swings over the life of an option is one of the most complex calculations in options trading. There is software available that can simplify the process, but investors need to understand the concept of volatility. The desirability of volatility depends on your option position. For example, if you are long in the option then volatility is a benefit for both put and call options.
The more volatility there is in the marketplace, the more likely the option will be in the money. That is why more volatility leads to higher premiums.
Two measures used to determine the relationship between the price of the option and the price of the underlying asset are delta and theta. The terms are called Greeks.
- Delta: a formula to measure the relationship between a change in an option's price and a change in the price of the underlying asset of the futures contract. Delta represents the percentage rate of change between prices. Values can range from -100 to 0 of talking about put options. Delta values range from 0 to 100 if talking about calls. Sometimes the delta ranges are expressed in decimal form.
- Theta: a formula that measures time decay. Time decay is the rate of change in the time premium. The time premium is the value to the option price due to the remaining time before contract expiration. Theta values increase from zero. The higher the Theta measure the more volatility exists due to time decay.
There are many option pricing models including the Black-Scholes and Cox-Ross-Rubinstein models. You don't have to complete the calculations yourself but you do need to understand the potential impact of volatility in the buying of stock options and options on futures contracts.
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