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Weekly Futures Market Commentary

Why, When, and How to Buy Options on Futures

by Jim Wyckoff, Senior Editor

In this educational feature I will discuss trading options on futures--specifically buying puts and calls. You can also sell options, but your financial risk is not limited like it is when you buy an option. I won't get into selling options in this feature.

I know that many beginning (and even veteran) traders think options trading is too complicated, and they don't have a clue about the vega, theta, delta and gamma pricing formulas--or the strangles, straddles, butterflies and other such options trading methods. Well, don't worry. I'm not going to get into those strategies in this column. 

Entire books have been written on options and options-trading strategies, but I will only focus on a few basic, low-risk and limited-risk trading strategies for beginning traders (and veterans, too). I'll also briefly talk about using options to "hedge" winning trading positions in volatile markets. I do suggest that if you are interested in trading options, you should read a book or two on options trading. Again, you don't have to be a rocket scientist to employ simple options-trading strategies.

First, I am going to assume readers know the definition of an option on a futures contract, and also the difference between a put option and a call option and "in the money" and "out of the money." (If you don't know the meaning of these terms, that's okay. Just go to one of the big futures exchange websites, and you can find a glossary of trading terms, digest the options terms and then read this article.)

A while back there was a big runup in the price of crude oil. It certainly was tempting for many traders to want to short that market at those sharply higher price levels. However, remember that to successfully trade futures you not only have to be right on market direction, you also have to be correct on the timing of the market move. Furthermore, you can be right on market direction and very close to being right on timing the trade, but still lose your trading assets because of market volatility. In crude oil, for example, a trader could have established a short position two days before the top in the market was in, and still be stopped out and lose his trading assets because of the high volatility.

Purchasing options allows you to limit your financial risk and let's you ride out volatile market swings without the worry of increased margin calls. 

Buying a put or a call that is "out-of-the-money" is a relatively inexpensive way to wade into futures trading. The money the trader lays out to his broker for the option purchase is all the trader has to worry about losing. No margin money. No margin calls. He can sleep well at night. And he is still trading futures, learning the business, honing his trading skills.

Here's another trading tactic to think about regarding purchasing options in volatile markets. Just because you have a protective buy stop or sell stop in place when trading straight futures contracts, that does not guarantee you will get out of the market (filled) close to your stop. For example, weather markets in the grains and soybean complex futures can produce limit price moves--sometimes for two or more sessions in a row. If you have a straight trading position on in soybeans and the market moves against you by the limit, or multiple limits, your protective stop is virtually worthless. But if you had hedged your straight futures position with a cheap out-of­the-money option purchase, you have limited risk in a volatile market. 

Let's say you are long soybeans at $5.00 in a highly volatile market. You initiated that trade on the long side, but then decided to purchase a $4.50 put option that limits your trading risk to 50 cents a bushel ($2,500 per contract), plus the price of the put option purchase. The trade-off here is that you are gaining peace of mind and losing some profit potential. But for many traders, that's well worth it. You can stay in the game to trade again another day, and won't get wiped out by a limit price move. 

There are trade-offs in purchasing and trading options on futures, as opposed to trading straight futures. If you purchase "out-of-the-money" options, the market has to move in your favor for a period of time before your option becomes "in-the-money." During periods of high market volatility, the prices of options can and usually do increase substantially.

One more thing: Anyone considering trading options on futures needs to check the open interest level on the particular "strike price" they are contemplating trading. Just like in straight futures trading, the more liquid (higher open interest) strike prices and options markets are usually more desirable to trade.