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Wednesday, November 7, 2007

What are "Futures Options"?

Ok, now that we've gotten through that? What is a "Futures Option"?

If you are familiar with stock options, then this will be much easier to explain. If not, I'll do my best . . .

When you purchase a Futures Option, you are purchasing the right, but not the obligation to buy a specific futures contract, at a predetermined price, within a given period of time.

That's it in a nutshell.

Now let me try to make it a bit easier, and perhaps you will see why I put those two statements in italics, and bold. When you hold a futures contract (not an option)? You have the right, and the obligation to buy and sell a specific futures contract; with all of the risks that implies, and that I discussed yesterday. In other words, your margin deposit is controlling one of the large and valuable contracts that's in the market. You are using a great deal of leverage to do so. Leverage is just what it sounds like. A lever, to move a larger object (unless of course, you have $80,000.00 cash to control one contract in the clear).

So, what's the difference with a futures option? 1) It expires before the Futures contract does. 2) It is an option that is tied to the value of the Futures contract 3) It has a set price. In other words, you put down $300.00? That's all you pay, and that is the maximum amount that you can lose as long as you do not exercise that option. But you are under no obligation to exercise it. You can trade it on it's singular value alone.

The reason options are valuable, is that at any time, provided you have the margin, you can exercise your option. This means, that you would call up your broker, and let them know that you want to exercise the option. When you exercise an option, the option is no longer in your account, and you are now within an established Futures contract position, at a price determined by whatever your Strike Price was that you specified when you bought the option. As I stated yesterday, is something I do not do. The risk to your account increases almost exponentially when you exercise an option, so I do not exercise the options I buy.

If you buy the right option (ah, therein lie the rub), then your option can gain just as much value as the futures contract, with none of the associated lock-limit risks.

How are futures options calculated? It's pretty complex. And no, I'm not kidding. It runs something like this:

C = S * N(d1) - K * (e ^ -rt) * N (d2)

ln (S / K) + (r + (sigma) ^ 2 / 2) * t
d1 = --------------------------------------
sigma * sqrt(t)

d2 = d1 - sigma * sqrt(t)


Where:
C = theoretical call premium
S = current stock price
N = cumulative standard normal distribution
t = time until option expiration
r = risk-free interest rate
K = option strike price
e = the constant 2.7183..
sigma = standard deviation of stock returns (usually written as lower-case 's')
ln() = natural logarithm of the argument
sqrt() = square root of the argument
^ means exponentiation (i.e., 2 ^ 3 = 8)

Don't worry. I deal with none of that when looking for a futures option. Heck, I had to go find the formula off the internet when writing this, because I had no idea what the actual formula was. What it basically says is that the further you are away from the STRIKE PRICE of the commodity, the less valuable the option will become, dependant upon 4 other factors, which include how long is it until the option expires (You pay more for an option, the further away it is, and that value decreases over time), how volatile is the market, interest rates, and other variables.

So in the end? I generally find an option that is the right option for the strategy I have in mind; (which I will discuss as time goes on). If you don't choose the right option? You can nickle and dime your account to death if you don't know how to find the right option that's applicable to your strategy.

That's it in a nutshell. Feel free to ask me any questions at secure.communication@gmail.com, and don't worry. I'll explain more as time goes on.

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