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Buying Options
By: Rick Thachuk   Wednesday, August 8, 2007 10:56 PM
If the trader thinks that it is unlikely that July cocoa futures will rally to over $1400 by this time, then he should not buy a call option with a strike price of 1400 or higher.

Let's say that the trader expects July cocoa to rise to 1385 by the time the options expire. The 1300 call option will be worth $850 at expiration, generating a net profit of $520 ($850 - $330 = $520) or a 158% return. The 1350 call option will be worth $350 at expiration, generating a net profit of $170 ($350 - $180 = $170) or a 94% return. In this case, the option with the 1300 strike price provides the better investment. The result will, of course, vary depending upon the futures price that is expected. For example, if July cocoa is expected to reach $1435 by option expiration, then the rate of return on the 1300 call option is 309% and on the 1350 call option, 372%.

Choosing an option often involves a trade-off between these two factors. In other words, the trader must balance risk (or cost of the option) with potential return. In this regard, choosing an option is no different than any other investment decision.

In the cocoa example, there is no clear choice between the 1300 and 1350 call option, although the 1300 call is probably the better investment over most bullish scenarios.

As a general rule of thumb, a near- or at-the-money option (an option whose strike price is close to the price of the underlying futures contract) is usually a good choice. In contrast, beginners should be cautious about buying options that are deeply out-of-the money. Despite its appeal, such a strategy rarely leads to consistent profitability, and this is the next topic.

Beware the Deep Out-of-the-Money Option

A call option is out-of-the-money if the strike price is above the market price of the underlying futures contract. A put option is out-of-the-money if the strike price is below the market price of the underlying futures contract. In both cases, the further away the strike price is from the market price, the deeper the option is out-of-the-money.

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