1. What is my maximum risk if I buy an option?
The nature and amount of downside risk is a good first question to ask about any investment you may be considering. In the case of options, the maximum risk is that you could potentially lose the money, known as the premium, which you invested to purchase that particular option. And, of course, you can lose the brokerage and transaction costs involved in making the investment. There can be no assurance any given option will become worthwhile to sell or exercise. Profitability depends on whether the price movement you anticipate occurs during the life of the option.
2. Aren’t options a risky investment?
Options are an inappropriate investment for some people. This is why your broker will ask you questions that may seem somewhat personal about your financial situation and objectives and will require that you acknowledge reading and understanding a Risk Disclosure document prepared by the Commodity Futures Trading Commission. Money needed for family living, insurance protection and basic savings programs obviously should never be committed to any form of investment that involves significant risk, regardless of the opportunity for profit.
3. Why have options on futures become such an increasingly popular investment?
Options make it possible to realize a potentially substantial profit, often in a short period of time, with a relatively small investment and with a known and limited risk. Under no circumstances can the loss exceed the cost of purchasing the option.
Other advantages include:·
- The leverage inherent in options.
- The liquidity provided by established competitive option markets.
- Investment diversification.
- The flexibility to respond rapidly to market opportunities.
- The ability to follow the value of your investment on a day-to-day basis.
- The staying power to weather temporary setbacks without incurring additional risk or costs.
- Freedom from the margin calls that many other investments are subject to.
- Strict federal industry regulation.
- The opportunity to realize profits during periods of falling as well as rising prices.
4. What exactly is an option?
There is regulated exchange trading in two types of options on futures contracts, known as call options and put options. Which one to consider investing in will depend entirely on your price expectations, that is, on whether you expect the price of a particular commodity to go up or you expect it to go down.
- Call option Purchasing a call gives you a specific locked-in price at which you have the right, but not the obligation, to buy a futures contract on a commodity that you expect to increase in value. For example, if you predict that the price of gold will go up, you’d buy a gold call option.
- Put option Purchasing a put gives you a specific locked-in price at which you have the right, but not the obligation, to sell a futures contract on a commodity that you expect to decrease in value. Thus, if you look for the price of gold to go down, you’d buy a gold put option.
One easy way to remember which is which is to think of the terms “call up” and “put down.” A call is a way to profit if prices go up. A put is a way to profit if prices go down. If and when the market price of the commodity moves in the direction you anticipated, this will be reflected on a daily basis in the value of your option.
5. Other than “call” and “put,” what terms do I need to be familiar with?
Just a couple. You should know what’s meant by an option’s “premium” and by its “strike price.”
Example: If a call option gives you the right to buy 100 ounces of gold at a price of $500 an ounce, $500 is the strike price. At any given time, there is likely to be trading in options with a number of different strike prices.
When you buy a call, you hope the market price of the commodity will move above the option’s strike price by an amount greater than the cost of the option, thereby causing the option to become profitable. When you buy a put, you hope that the market price of the commodity will decline below the option’s strike price by an amount greater than the cost of the option.
6. How are profits realized in option investing?
Generally by instructing your broker to sell your appreciated option rights to someone who may have an interest in exercising them. The sale will be accomplished on the trading floor of the exchange (the same exchange where the option was bought) and your net profit will be the difference between the price that you originally paid for the option and the higher price that you are able to sell it for, less brokerage and transaction expenses. The mechanics are no more complicated than, for example, selling shares of common stock that have appreciated. An alternative to selling a profitable option is to exercise the option rights. Doing this, however, would result in your actually acquiring a position in the futures market – which could require an additional investment on your part and involve significantly greater risks. Most investors therefore prefer to realize their profits by simply selling the option at its increased value.
7. As an example, if I buy an Option to purchase 100 ounces of gold at a strike price of $500 an ounce and the price of gold goes to $540 an ounce, what’s my profit?
If gold climbs to $540 an ounce at expiration, your call option with a $500 strike price will have a value of $4,000 – the $40 an ounce price increase times 100 ounces. The profit will depend on what you paid for the option to start with. If your total costs (premium plus brokerage and transaction costs) were, say, $800, then your profit will be $3,200 – the difference between the $800 you paid for the option and the $4,000 you can now sell it for. As mentioned, the same broker who handled the purchase can handle the sale.
Illustration of profit or loss on a 100-ounce gold call option if the option strike price is $500 an ounce and the cost of purchasing the option was $800 ($8 an ounce):
|If gold futures price at expiration is||Value of option at expiration||Cost of option||Your profit|
|$500 or less||0||$800||$800 loss|
8. How large is my profit potential when I buy an option?
There is no upper limit on the opportunity for profit. The greater the price movement, provided it’s in the direction you anticipated and provided it occurs during the life of the option, the larger the profit. As previously indicated, it is the combination of limited risk and unlimited opportunity that is a principal attraction of options as an investment vehicle.
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