Buying Options: An Introductory Guide

Early in my career there was one area of trading that I avoided like the plague - buying options, or options on futures, to be precise.  I thought they were too complicated, too expensive, too risky. It took me a long time to learn that all my fears were misguided. In fact, options have ended up being the most profitable part of my trading by far.

Now, I was no maths maven in school. I've struggled since Mr. Richardson's 6th grade maths tests, especially the five-minute one. (I still wake up in a cold sweat over that one.) Let me tell you, his maths tests kept me after school many a day and destroyed any interest in maths that I may ever have had.  All through the rest of my academic life I always did exceptionally well in vocabulary, reading, and writing, but stunk at maths in all forms except geometry, which my brain confused with drawing. Still, to this day, I'm a terrible mathematician and rely on all the modern-day conveniences, like accountants.

Anyway, if you spent a lot of time after school for maths as well, then you may think you're not able to trade options. Think again.

Some options books can be mind-boggling, with complicated mathematical equations and lots of detailed explanations that would mystify even Einstein, all to try and explain a simple concept.

We won't go into great detail here; there are plenty of resources for that on the Internet or in your local bookstore. All you need to do is understand the basics of buying options and how they can immediately benefit your portfolio in ways you couldn't imagine. Right about now you're probably saying, "OK, how?"

• Options limit risk and give you unlimited profits.
• Options give you tons of leverage in an already highly leveraged market.
• Options can allow you to trade markets you may not otherwise be able to afford to trade due to extremely high margins (e.g., natural gas, gold, crude oil).
• Options limit risk and give you unlimited profits. Worth repeating this one.

Before you do anything, you simply must learn the basics of buying options, there are no two ways about that - even the Maniac Trader had to succumb at some point! Forget your fear - if this 6th grade maths dropout can do it and be consistently successful, so can you.

So let's begin.  A "call" option is the kind of option we buy when we think the market is going higher; a "put" option is what we buy when we think the market is headed lower. Either way, the goal is the same: to make money from the difference between the strike price of the option and the current market rate of the investment. Right now we'll only discuss buying options.  Buying options, either puts or calls, involves limited risk and unlimited profit potential. You can sell options, also called "writing" options, but this carries with it limited profit potential and unlimited risk. Selling or shorting options is highly risky; if you're new to trading and even if you're not, many brokerage firms won't even let you do it.  So let's just focus on buying calls and puts.

When we buy a call or put we have to pay what is called "premium." Premium is a fancy way of saying what you're going to have to fork over for the option position. You can calculate what a fair premium should be in many ways, but at first it's best to work with a broker who has experience in calculating what a fair value for the option is; get them to help you learn how to do it and don't take no for an answer.

Most of the time you can find out where the option that you want to buy is trading just like you can get futures quotes-in the newspaper or on the Internet. If not, your broker can call the floor and get a fresh quote, much as they may do with spread orders. It's a good idea anyway, because sometimes there are so many options they don't all get updated and the price information on the screen may not be the most current. Always check first before trading.

Now I've gotten ahead of myself a bit.  Why exactly am I buying an option in the first place?  Why not just buy a cattle market futures contract if I think it's going higher? Great question. Answer: Two B-I-G advantages.

The first huge advantage is that when you buy options you're not required to put up any margin.  Nope…zip, zero, nada.  In other words, for something like cattle futures you would need to put up around $945 per contract as a guarantee or margin, and that money would remain locked up for the length of the trade. If you were to buy a cattle option instead, you would not have to post the margin at all, and could use that $945 toward other trades or simply keep it liquid. This is one of the greatest attractions of trading options: not tying up capital with margins.

Second, options allow you to control a vast amount of a particular commodity at a ridiculously low price. Leverage again - we love leverage! As you know, futures allow you to do this, but to a much lesser extent. Also futures carry unlimited risk as I pointed out earlier, while the risk in options is limited to just the premium you pay, nothing more.  Now the trick is finding bargains in options and knowing what the risk/reward potential is. This is where many traders come unstuck. 

Make no mistake, there are plenty of blunders people make when it comes to buying options, but a few really stand out and I'll share them with you now.

First, chasing the market doesn't pay. Never, never, never do this.  This holds true even more so for options than for futures.  Chasing after a trade in a market means you'll end up paying too much or selling for too little. In options trading this can mean the difference between consistently making and losing money.  Remember, options have an intrinsic value when you purchase them and the time value is always whittling away.  The option is constantly depreciating, like some new car from hell. So avid overpaying for an option at all costs - it will be even harder to turn a profit when it comes time to close the position.

Time is on your side…don't buy options with too little time value.  Time value is one of the most important things in options, and for that asset you have to pay more premium, but it can be worth it. The more time you have on your side the more chance your trade has of making money.  Buy too close in, say one or two months, and you may not have enough time until expiration for any real price movement. I don't advise trading options with less than three months until expiration or more than 18 months. 

Remember: "cheap" doesn't always mean good. Also, stay away from way out-of-the-money strike prices. Way, way out-of-the-money strike prices for commodities may be cheaper but the old saying, "you get what you pay for" usually applies.  If the option is so far out-of-the- money, say in heating oil, that it will take an ice-age to get to that price level, then "cheap" is a relative term.  Try to buy a strike price that's only slightly out-of-the-money unless you feel very strongly that the market is going to make a significant move in your favor; then you want to buy deep, way out-of-the-money options, as they're called.

There are plenty more pitfalls. And as important as knowing what not to do is learning what you should do to get a decent entry point for an option, which I will discuss next time.

Regards,

Kevin Kerr
for The Daily Reckoning Australia

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