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Part Three: The Mechanics of Buying and Writing Options

This publication is the property of the National Futures Association.

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Commission Charges
Before you decide to buy and/or write (sell) options, you should understand the other costs involved in the transaction—commissions and fees. Commission is the amount of money, per option purchased or written, that is paid to the brokerage firm for its services, including the execution of the order on the trading floor of the exchange. The commission charge increases the cost of purchasing an option and reduces the sum of money received from writing an option. In both cases, the premium and the commission should be stated separately.

Each firm is free to set its own commission charges, but the charges must be fully disclosed in a manner that is not misleading. In considering an option investment, you should be aware that:

• Commission can be charged on a per-trade or a round-turn basis, covering both the purchase and sale.

• Commission charges can differ significantly from one brokerage firm to another.

• Some firms have fixed commission charges (so much per option transaction) and others charge a percentage of the option premium, usually subject to a certain minimum charge.

• Commission charges based on a percentage of the premium can be substantial, particularly if the option is one that has a high premium.

• Commission charges can have a major impact on your chances of making a profit. A high commission charge reduces your potential profit and increases your potential loss.

You should fully understand what a firm’s commission charges will be and how they’re calculated. If the charges seem high—either on a dollar basis or as a percentage of the option premium—you might want to seek comparison quotes from one or two other firms. If a firm seeks to justify an unusually high commission charge on the basis of its services or performance record, you might want to ask for a detailed explanation or documentation in writing.

Leverage
Another concept you need to understand concerning options trading is the concept of leverage. The premium paid for an option is only a small percentage of the value of the assets covered by the underlying futures contract. Therefore, even a small change in the futures contract price can result in a much larger percentage profit—or a much larger precentage loss—in relation to the premium. Consider thefollowing example:

An investor pays $200 for a 100-ounce gold call option with a strike price of $300 an ounce at a time when the gold futures price is $300 an ounce. If, at expiration, the futures price has risen to $303 (an increase of only one percent), the option value will increase by $300 (a gain of 150 percent on your original investment of $200).

But always remember that leverage is a two edged sword. In the above example, unless the futures price at expiration had been above the option’s $300 strike price, the option would have expired worthless, and the investor would have lost 100 percent of his investment plus any commissions and fees.

The First Step: Calculate the Break-Even Price
Before purchasing any option, it’s essential to precisely determine what the underlying futures price must be in order for the option to be profitable at expiration. The calculation isn’t difficult. All you need to know to figure a given option’s break-even price is the following:

• The option’s strike price;
• The premium cost; and
• Commission and other transaction costs.

Determining the break-even price for a call option
Option         Option             Commission           Break
strike     +    premium     +    & transaction   =   even
price                                  costs                    price

Example: It’s January and the 1,000 barrel April crude oil futures contract is currently trading at around $12.50 a barrel. Expecting a potentially significant increase in the futures price over the next several months, you decide to buy an April crude oil call option with a strike price of $13. Assume the premium for the option is 95¢ a barrel and that the commission and other transaction costs are $50, which amounts to 5¢ a barrel.

Before investing, you need to know how much the April crude oil futures price must increase by expiration in order for the option to break even or yield a net profit after expenses. The answer is that the futures price must increase to $14 for you to break even and to above $14 for you to realize any profit.

______________________________________________________________
Option strike                          Commission &                 Break-even
price                 + Premium    + transaction costs          = price
$13.00              +  95¢         + 5¢                              = $14.00
______________________________________________________________

The option will exactly break even if the April crude oil futures price at expiration is $14 a barrel. For each $1 a barrel the price is above $14, the option will yield a profit of $1,000.

If the futures price at expiration is $14 or less, there will be a loss. But in no event can the loss exceed the $1,000 total of the premium, commission and transaction costs.

Determining the break-even price for a put option
The arithmetic is the same as for a call option except that instead of adding the premium, commission and transaction costs to the strike price, you subtract them.

Option         Option            Commission          Break
strike    –     premium    –    & transaction   =  even
price                                 costs                  price

Example: The price of gold is currently about $300 an ounce, but during the next few months you think there may be a sharp decline. To profit from the price decrease if you are right, you consider buying a put option with a strike price of $295 an ounce. The option would give you the right to sell a specified gold futures contract at $295 an ounce at any time prior to the expiration of the option.

Assume the premium for the put option is $3.70 an ounce ($370 in total) and the commission and transaction costs are $50 (equal to 50¢ an ounce).

For the option to break even at expiration, the futures price must decline to $290.80 an ounce or lower.

__________________________________________________________
Option strike                                     Commission &             Break-even
price                 –      Premium     –     transaction costs   =   price
$295                 –     $3.70         –     50¢                     =   $290.80
__________________________________________________________

The option will exactly break even at expiration if the futures price is $290.80 an ounce. For each $1 an ounce the futures price is below $290.80 it will yield a profit of $100. If the futures price at expiration is above $290.80, there will be a loss. But in no case can the loss exceed $420—the sum of the premium ($370) plus commission and other transaction costs ($50).

Factors Affecting the Choice of an Option
If you expect a price increase, you’ll want to consider the purchase of a call option. If you expect a price decline, you’ll want to consider the purchase of a put option. However, in addition to price expectations, there are two other factors that affect the choice of option:

• The length of the option; and
• The option strike price

The length of the option
One of the attractive features of options is that they allow time for your price expectations to be realized. The more time you allow, the greater the likelihood the option will eventually become profitable. This could influence your decision about whether to buy, for example, an option on a March futures concontract or an option on a June futures contract.

Bear in mind that the length of an option (such as whether it has three months to expiration or six months) is an important variable affecting the cost of the option. A longer option commands a higher premium.

The option strike price
The relationship between the strike price of an option and the current price of the underlying futures contract is, along with the length of the option, a major factor affecting the option premium. At any given time, there may be trading in options with a half dozen or more strike prices—some of them below the current price of the underlying futures contract and some of them above.

A call option with a low strike price will have a higher premium cost than a call option with a high strike price because it will more likely and more quickly become worthwhile to exercise. For example, the right to buy a crude oil futures contract at $11 a barrel is more valuable than the right to buy a crude oil futures contract at $12 a barrel.

Conversely, a put option with a high exercise price will have a higher premium cost than a put option with a low exercise price. For example, the right to sell a crude oil futures contract at $12 a barrel is more valuable than the right to sell a crude oil futures contract at $11 a barrel.

While the choice of a call option or put option will be dictated by your price expectations, and your choice of expiration month by when you look for the expected price change to occur, the choice of strike price is somewhat more complex. That’s because the strike price will influence not only the option’s premium cost but also how the value of the option, once purchased, is likely to respond to subsequent changes in the underlying futures contract price. Specifically, options that are out-of-the-money do not normally respond to changes in the underlying futures price the same as options that are at-the-money or in-the-money.

Generally speaking, premiums for out-of-themoney options do not reflect, on a dollar for dollar basis, changes in the underlying futures price. The change in option value is usually less. Indeed, a change in the underlying futures price could have little effect, or even no effect at all, on the value of the option. This could be the case if, for instance, the option remains deeply out-of-the-money after the price change or if expiration is near.

If you purchase an out-of-the-money option, bear in mind that no matter how much the futures price moves in your favor, the option will still expire worthless, and you will lose your entire investment unless the option is in-the-money at the time of expiration. To realize a profit, it must be in-the-money by some
amount greater than the option’s purchase costs. This is why it’s crucial to calculate an option’s break-even price before you buy it.

Example: At a time when the March crude oil futures price is $11 a barrel, an investor expecting a substantial price increase buys a
March call option with a strike price of $12.50. By expiration, as expected, there has been a substantial price increase to $12.50. But since the option is still not worthwhile to exercise, it expires worthless and the investor has lost his total investment.

After You Buy an Option, What Then?
At any time prior to the expiration of an option, you can:

• Offset the option.
• Continue to hold the option.
• Exercise the option.

Offsetting the option
Liquidating an option in the same marketplace where it was bought is the most frequent method of realizing option profits. Liquidating an option prior to its expiration for whatever value it may still have is also a way to reduce your loss (by recovering a portion of your investment) in case the futures price hasn’t performed as you expected it would, or if the price outlook has changed.

In active markets, there are usually other investors who are willing to pay for the rights your option conveys. How much they are willing to pay (it may be more or less than you paid) will depend on (1) the current futures price in relation to the option’s strike price, (2) the length of time still remaining until expiration of the option and (3) market volatility.

Net profit or loss, after allowance for commission charges and other transaction costs, will be the difference between the premium you paid to buy the option and the premium you receive when you liquidate the option.

Example: In anticipation of rising sugar prices, you bought a call option on a sugar futures contract. The premium cost was $950 and the commission and transaction costs were $50. Sugar prices have subsequently risen and the option now commands a premium of $1,250. By liquidating the option at this price, your net gain is $250. That’s the selling price of $1,250 minus the $950 premium paid for the option minus $50 in commission and transaction costs.

Premium paid for option                 $ 950

Premium received when option
is liquidated                                  $ 1,250
                                                     ______
Increase in premium                      $ 300

Less transaction costs                   $  50
                                                     _____
Net profit                                     $  250

You should be aware, however, that there is no guarantee that there will actually be an active market for the option at the time you decide you want to liquidate. If an option is too far removed from being worthwhile to exerciseor if there is too little time remaining until expiration, there may not be a market for the option at any price.

Assuming, though, that there’s still an active market, the price you get when you liquidate will depend on the option’s premium at that time. Premiums are arrived at through open competition between buyers and sellers according to the rules of an exchange.

Continuing to hold the option
The second alternative you have after you buy an option is to hold an option right up to the final date for exercising or liquidating it. This means that even if the price change you’ve anticipated doesn’t occur as soon as you expected—or even if the price initially moves in the opposite direction—you can continue to hold the option if you still believe the market will prove you right. If you are wrong, you will have lost the opportunity to limit your losses through offset. On the other hand, the most you can lose by continuing to hold the option is the sum of the premium and transaction costs. This is why it is sometimes said that option buyers have the advantage of staying power. You should be aware, however, options decline in value as they approach expiration. (See “Time Value”.)

Exercising the option
You can also exercise the option at any time prior to the expiration of the option. It does not have to be held until expiration. It is essential to understand, however, that exercising an option on a futures contract means that you will acquire either a long or short position in the underlying futures contract—a long futures position if you exercise a call and a short futures position if you exercise a put.

Example: You’ve bought a call option with a strike price of 70¢ a pound on a 40,000 pound live cattle futures contract. The futures price has risen to 75¢ a pound. Were you to exercise the option, you would acquire a long cattle futures position at 70¢ with a “paper gain” of 5¢ a pound ($2,000). And if the futures price were to continue to climb, so would your gain.

But there are both costs and significant risks involved in acquiring a position in the futures market. For one thing, the broker will require a margin deposit to provide protection against possible fluctuations in the futures price. And if the futures price moves adversely to your position, you could be called upon—perhaps even within hours—to make additional margin deposits. There is no upper limit to the extent of these margin calls.

Secondly, unlike an option which has limited risk, a futures position has potentially unlimited risk. The further the futures price moves against your position, the larger your loss.

Even if you were to exercise an option with the intention of promptly liquidating the futures position acquired through  exercise, there’s the risk that the futures price which existed at the moment may no longer be available by the time you are able to liquidate the
futures position. Futures prices can and often do change rapidly.

For all these reasons, only a small percentage of option buyers elect to realize option trading profits by exercising an option. Most choose the alternative of having the broker offset—i.e., liquidate—the option at its currently quoted premium value.

Who Writes Options and Why
Up to now, this booklet has discussed only the buying of options. But it stands to reason that when someone buys an option, someone else sells it. In any given transaction, the seller may be someone who previously bought an option and is now liquidating it. Or the seller may be an individual who is participating in the type of investment activity known as option writing.

The attraction of option writing to some investors is the opportunity to receive the premium that the option buyer pays. An option buyer anticipates that a change in the option’s underlying futures price at some point in time prior to expiration will make the option worthwhile to exercise. An option writer, on the other hand, anticipates that such a price change won’t occur—in which event the option will expire worthless and he will retain the entire amount of the option premium that was received for writing the option.

Example: At a time when the March U.S. Treasury Bond futures price is 125-00, an investor expecting stable or lower futures prices (meaning stable or higher interest rates) earns a premium of $400 by writing a call option with a strike price of 129. If the futures price at expiration is below 129-00, the call will expire worthless and the option writer will retain the entire $400 premium. His profit will be that amount less the transaction costs.

While option writing can be a profitable activity, it is also an extremely high risk activity. In fact, an option writer has an unlimited risk. Except for the premium received for writing the option, the writer of an option stands to lose any amount the option is in-the-money at the time of expiration (unless he has liquidated his option position in the meantime by making an offsetting purchase).

In the previous example, an investor earned a premium of $400 by writing a U.S. Treasury Bond call option with a strike price of 129. If, by expiration, the futures price has climbed above the option strike price by more than the $400 premium received, the investor will incur a loss. For instance, if the futures price at expiration has risen to 131-00, the loss will be $1,600. That’s the $2,000 the option is inthe-money less the $400 premium received for writing the option.

As you can see from this example, option writers as well as option buyers need to calculate a break-even price. For the writer of a call, the break-even price is the option strike price plus the net premium received after transaction costs. For the writer of a put, the breakeven
price is the option strike price minus the premium received after transaction costs.

An option writer’s potential profit is limited to the amount of the premium less transaction costs. The option writer’s potential losses are unlimited. And an option writer may need to deposit funds necessary to cover losses as often as daily.

Risk Caution
Option writing as an investment is absolutely inappropriate for anyone who does not fully understand the nature and the extent of the risks involved and who cannot afford the possibility of a potentially unlimited loss. It is also possible in a market where prices are changing rapidly that an option writer may have no ability to control the extent of his losses. Option writers should be sure to read and thoroughly understand the Risk Disclosure Statement that is provided to them.