Futures and Options Q & A | PFG Futures
8. When I buy an Option, how is the Premium cost arrived at?
As previously mentioned, the premium refers to the price you pay to buy an option. Like prices on the trading floor of a stock exchange or a futures exchange, option “premiums” are arrived at through open competition between brokers representing buyers and sellers. Option markets are thus quite literally supply and demand market places. Trading is subject to the rules of the exchange and is closely regulated by the Commodity Futures Trading Commission (CFTC), a federal agency. Firms that deal in options are also subject to CFTC regulation by the National Futures Association (NFA); the industry’s congressionally authorized self-regulatory organization.
9. What Brokerage Commissions are involved in Buying Options?
Brokerage firms differ in the services they provide, in the markets that they know best, in their success in helping clients identify potentially profitable investment opportunities, and in the commissions that they charge. Provided commissions are stated in a clear and forthright manner, each firm can set their own rates – the same as firms do in the securities industry. Nevertheless, commissions can be a large variable in an option’s profit equation. You should be satisfied that they are fair and reasonable in relation to the services and advice being provided.
10. It’s often said a major advantage of Options is Leverage. What does this mean?
The greater the leverage, which options provide, means that even a small favorable movement, (a price change up or down), in the underlying commodity price can yield a high percentage rate of return on your investment.
Example: Say you’ve invested $800 (the premium, plus commissions, and fees) to buy one gold call option contract with a strike price of $400, which expires in 3 months. Remember, one gold option contract is equal to 100 ounces of gold, hence, the leverage: you are leveraged to $40,000 of gold for only $800. At $400 per ounce, the value of the underlying futures contract is $40,000. So, for $800, you are “leveraged” for 100 ounces of gold to move either up or down.
11. How long is the life of an Option?
Normal trading in options is anywhere from less than a month, to twelve months or more. The choice is yours. This flexibility makes it possible to select whichever option best coincides with your expectations.
Example: Buying an option that expires in September allows two extra months for an expected price change to take place versus buying an option that expires in July.
Purchasing a longer-term option will increase the premium cost of the option somewhat, but as with most things, it’s usually best to allow a little extra time for an expected event to occur! Don’t hesitate to seek your broker’s assistance in deciding the contract month and the expiration date when purchasing an option.
12. Suppose I buy a Call Option contract in Heating Oil, which is leveraged at 42,000 gallons, and the price of Heating Oil goes up 10 cents above my “strike price.” What’s my Profit?
If Heating Oil climbs $.10 above your “strike price” at or before expiration, your call option will have a market value of approximately $4,200. The $.10 move above your “strike price,” times the contract size of 42,000 gallons, equals $4,200 ($.10 x 42,000 gallons =$4,200). The profit will depend on what you paid for the option to start with.
If your total costs (premium, plus commissions and fees) was, say, $1,000, then your profit will be $3,200. This is the difference between the $1,000 you paid for the option, and the $4,200 you could now sell the option. A $3,200 profit on a $1,000 investment is a 320% return on that investment! Heating Oil can make a 10 cent move above or below your “strike price,” or not at all, in a matter of weeks or months.
An illustration of the Profit and/or Loss of a 42,000 gallon Heating Oil “call” option, assuming the cost of purchasing the “call” was $1,000.
If the Heating Oil “futures” price is
at, or above, the
Value of Option
|at or below strike price||$ 0||$1000||– $1000 loss|
|$.02 above strike price||$ 840||$1000||– $ 160 loss|
|$.04 above strike price||$ 1680||$1000||+$ 680 profit|
|$.06 above strike price||$ 2520||$1000||+$ 1520 profit|
|$.08 above strike price||$ 3360||$1000||+$ 2360 profit|
|$.10 above strike price||$ 4200||$1000||+$ 3200 profit|
|$.12 above strike price||$ 5040||$1000||+$ 4040 profit|