Many traders often start with the simple strategy of buying options. This is a comparatively safe investment approach relative to trading futures outright, and the general idea that the purchase of options limits downside risk to the option premium plus commission and fees is well understood by most. Confusion often arises, however, when trying to understand the movement in price of an option relative to the movement in price of the underlying futures. On a day when the underlying futures moves in a significantly favorable direction, option buyers can be disillusioned upon discovering that their option values have risen by half, or even less than half, of that amount.
An example will make this clear. Assume that cotton futures rise 1.06 cents over the day to settle at 62.70 cents. Shown below are changes in the settlement price of various call and put cotton options over the same day. Because the futures rose over the day, all call options rose in value while all put options fell in value. Note, however, that the changes in option values are less than that of the underlying cotton futures. For instance, an individual holding the at-the-money 62 call option saw an increase in value of only 0.44 cents. For those traders holding call options with higher strike prices, the increase was even less.
Call Options Put Options
Strike Price Change Strike Price Change
61 2.60 +.59 58 .26 -.18
62 2.00 +.44 59 .40 -.26
63 1.50 +.40 60 .62 -.33
64 1.10 +.30 61 .91 -.46
65 0.79 +.22 62 1.30 -.56
The sample option prices shown above highlight the following fact:
At-the-money options (whether calls or puts) will move in price by approximately half of the amount of the underlying futures contract. Options that are progressively more out-of-the-money (whether calls or puts) will move in price by a lesser and lesser amount, and options that are progressively more in-the-money will move in price by a larger and larger amount. In the extreme, an option which is deeply out-of-the-money will move in price hardly at all when the underlying futures moves, while an option that is deeply in-the-money will move in price by essentially the same dollar amount as the underlying futures. (In this latter case, the deep in-the-money option behaves much like a futures contract.)
The sensitivity of an option's price to a change in the price of the underlying futures is called the delta of an option. That is, for a full point movement in the price of the underlying futures, the delta of an option provides an indication of the corresponding change in price expected for the option. Call options have a positive delta (since call option prices rise with futures prices, and vice-versa) and put options have a negative delta (since put option prices fall as futures prices rise, and vice-versa).
The delta of an option is a consequence of the time value of an option, and it changes as futures prices move and as the option approaches expiration. For the beginner, the important message is that when purchasing options, especially out-of-the-money options that are relatively cheap, a rather large movement in price of the underlying futures will be needed before such options appreciate significantly in value. This should be kept in mind when determining the investment strategy with the best risk/return profile.
