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Which Option to Buy?

 August 08, 2007 11:04 PM


 

Buying options on futures has the advantage of limiting downside risk. The most you can lose on an option purchase is the cost of the option (including commissions), and that's all. If you think that the price of a commodity, say, corn is going to rise, then buy call options on corn. If, on the other hand, you feel that corn will fall in price, then buy put options on corn. It's that simple...or is it?

For each expiration month, options are listed having several strike prices. For example, assume that it is now November and that we are interested in corn options that expire the following March. Listed below are sample prices for March call options on corn having a strike price that range from 260 cents per bushel to 320 cents per bushel.

March Corn Call Options
Strike Open High Low Closing Range Settle Net Chge
260 28 28 27 1/4 27 1/4 27 1/4 -7/8
270 20 21 19 1/2 19 3/4 to 20 19 7/8 -1/2
280 14 1/2 14 3/4 13 1/2 13 3/4 13 3/4 -1/2
290 9 1/2 10 9 9 1/8 to 9 1/4 9 1/8 -1/2
300 7 7 6 6 1/8 6 1/8 -1/2
310 4 1/2 4 1/2 4 4 to 4 1/8 4 -3/8
320 3 3 2 1/2 2 7/8 2 7/8 -1/8

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Notice that the price of a call option depends upon the strike price. Call options having a high strike price cost less than call options having a lower strike price, all else constant. For example, the 310 call option costs only $200 (calculated as 4 cts/bu x 5,000 bu) plus commission and fees, while the 270 call option costs $993.75 (calculated as 19.875 cts/bu x 5,000 bu) plus commission and fees. When determining which option to buy, consider the price. Buy an option that you can afford. For instance, you may want to only pay between $400 and $700 for an option. Don't be tempted by inexpensive call options having a very high strike price. While they may be cheap, it is also likely that they will expire worthless, since the price of the underlying futures must rise beyond the strike price of the call option by the time the option expires for it to have value upon expiration.

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Try to pick an option that falls within your cost range and that has a strike price fairly close to the price of the underlying futures contract. This option is called an at-the-money option. At-the-money options tend to be the most liquid and actively traded options. For instance, if corn futures settled at 286 cents/bushel, then the 280 and 290 call options are at-the-money. The 290 call option settled at 9 1/8 cents per bushel, giving it a price of $456.25 which falls within the price range. This, then, seems like a good choice.

The above example compared the prices of call options that expired in March. Options that have a longer time until expiration will cost more. For instance, the 290 call option that expires in May may trade at 16 1/8 cents per bushel, or $806.25.


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Buying Options Understanding Option Prices
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