Options Trading for Beginners: Start With a Four-Letter Word…

****!!? No, hopefully not that one. ‘Risk’ is the four-letter word that motivates and shapes options trading and it is something you’ll want to understand thoroughly—and  be confident of managing appropriately, before getting into this investment strategy.

Trading in the commodities and futures market involves substantial risks and it isn’t suitable for everyone. Because the amount of initial margin is small relative to the value of a futures contract, a relatively small market movement can have a proportionately larger impact on your capital. This is both the good news and bad news of option trader beginners.

There are strategies that can be used to mitigate risk to varying degrees. For example, “stop-loss” orders tell your broker to buy or sell a particular futures contract at the best immediately available price once the price reaches a designated level. This is a very useful risk-management tool, but you should be aware there are circumstances that can make it ineffective: for example, if the market price is rising or dropping too rapidly for your position to be liquidated at your designated price, or if the “lock limit” is reached (the maximum amount the price is allowed to rise or fall before trading is stopped). Your broker can explain other strategies, such as “spreads,” that may have risk-management benefits.

Options trading is a risk-management strategy you have probably heard of if you are familiar with the stock market, and options are traded on most active futures contracts as well. Options are attractive because purchasing them rather than their underlying contracts enables you to speculate on the movement of futures prices while limiting your potential losses to a known amount—the cost of purchasing the option (the “premium”) plus transaction costs.

How do options work? If you believe the cost of a futures contract will go up, you could purchase a call option. This gives you the right, but not the obligation, to buy that contract at a specified price (the “exercise” or “strike” price) at any time during the life of the option. If your prediction is correct and the price rises, you can make a profit by purchasing the contract at the lower strike price and selling it at the higher current market value. Of course, your real profit will be reduced by the amount of the premium you paid for the call option plus transaction fees, so be sure to calculate in advance how high the contract price must rise before your costs are covered and your base profit level is reached.

If the contract price never reaches your base profit level, you will have a net loss. If your prediction that the price will rise is just dead wrong, you can lose the entire amount of your premium plus transaction costs. But this is all you can lose, no matter how low the price level dips.

If you believe the cost of a particular futures contract will go down, you could purchase a put option, which gives you the right, but not the obligation, to sell the contract at a specified price. Once again, if you’re wrong, all you can lose is your premium plus transaction costs. If you’re right, you can purchase the contract at the lower market price and sell it at the higher exercise price. Your profit potential in options trading is theoretically limitless, but is always reduced by the premium amount paid for the option.

Options themselves can also be sold during their life span, to realize a profit or reduce a loss. The premium you’ll pay for an option, or for which you can sell your unexpired option, is determined by three factors:
•    The relationship between the exercise price and current market price of the underlying contract. In other words, how far does the market price have to move to reach your base profit level? Options that are way “out of the money” can be quite cheap, but their chance of becoming profitable can be quite low.
•    The length of time remaining until expiration. The more time an option has to become profitable, the higher the premium.
•    The volatility of the underlying contract. The greater the volatility, the higher the premium. A sluggish commodity is less likely to achieve your price goals within the option’s time frame.