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Buying Options
By: Rick Thachuk   Wednesday, August 8, 2007 10:56 PM
Multiply this number by the tick value to calculate the option price.

When calculating option prices, use the following as approximate guidelines for checking your answer:

  • Call options become less expensive the higher the strike price.
  • Put options become more expensive the higher the strike price.
  • Call and put options become more expensive the longer the time to expiration.
  • For most markets (not including the equity index markets), the value of an at-the-money call or put option with one month to expiration usually falls between $400 and $1,500. If your calculation produces a price far outside of this range, you may have an error.

After a little practice, you should be able to read option prices quickly and easily and then you can move on to the next step: Selecting the proper strike price.

Selecting the Proper Strike Price

For any call or put option of a specific contract month, a list of options is available each having a different strike price. Consider, for example, call options on July cocoa futures. Assume that it is early May and that July cocoa futures are trading at $1306. Below are sample prices of a series of July cocoa call options. The price for each is shown in ticks, as it is customarily quoted, and then in dollars. Each tick in cocoa is worth $10.

July Cocoa Call Options
Strike Price (ticks) Price ($)
1250 61 $610 
1300 33 $330
1350 18 $180
1400 11 $110

Note that the prices of these call options vary depending upon the strike price. The lower the strike price, the more expensive the call option. This makes sense because a call option gives the holder the right to acquire the underlying futures contract at the strike price. A lower strike price means the option holder can acquire the futures at a cheaper price, but the option buyer must pay for this privilege by paying more money for the option. The two almost exactly offset each other, so there are no quick and riskless profits that can be made. This is ensured by professional arbitrage within the trading pit.

A trader who expects cocoa to rise by the time the July option expires will buy a cocoa call option. The question is: Which one?

When selecting an option, the trader must first determine how much he wants to spend (risk). The most that an option buyer can lose is the cost of the option plus transaction and other fees. For example, if a trader wants to spend no more than $500 on a July cocoa call option, then the 1250 strike option would be excluded from the list because it is too expensive.

The trader can then choose among the financially affordable options by comparing the various strike prices with the trader's forecast of the price of the underlying futures contract. For example, the July cocoa options expire in early June.

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