Despite the growing use of options, many potential users have
yet to tap these markets and take
advantage of the potential benefits they
offer. One of the major reasons for that
is the frequently expressed perception
that options are too difficult and time-consuming
to learn. Without a doubt,
these markets involve their share of terminology
Options on financial futures
need not be a difficult topic. The information here may help you to understand how options are used, but understanding how options work is only part of determining whether this kind of investing is right for you.
These instruments may not be suitable for even those who have a full understanding of how they work. Due to the risks, a determination of financial suitability is essential when it comes to options. While the risk for the buyer of an option is limited to the amount paid for the option (along with fees and commissions), for the seller of an option, the risk of loss can be unlimited. Also, for both buyers and sellers, because of the leverage associated with options, small market moves against a position can result in rapid losses.
One place to start to determine if options are right for you is to ask the question: “What can options do
One of the most common commercial applications of options on futures is the short hedge,
A put option purchase is used when a bear market
You will realize a profit on
the position as long as the option’s
intrinsic value at expiration is greater
than the amount you paid for it.
Put options are completely separate
and distinct from call options. They
are similar to calls, though, in setting
limits on gains or losses. But since
puts provide the buyer with the right
to assume a short futures position, the
payoff profiles for puts “change direction”
as compared to calls. To illustrate,
the diagram shows the payout
profile of a short futures position.
Compare that with the payout profile
for holding a put option.
The put buyer has a bearish market
sentiment but has limited risk exposure on the
upside. Like the call buyer, he pays the
premium up front for the rights granted
by the option. In contrast, the person
who sold the put option would experience
a mirror image payoff profile.The
premium is the most you can lose in
a put purchase.
You will have to decide which strike
price best suits your needs and level
of risk tolerance. In-the-money puts cost more but
offer better break-even points. If you
purchased an out-of-the-money put
you would pay less up front, but the
market would have to move much
further in your favor for you to see
a profit. A comparison of put option
payoff profiles appears below:
Here is an example of how to use a put option to hedge a declining market.
For the sake of simplicity, we will assume that the option position
is held until expiration.
Of course, you don’t have to hold
your option to expiration. Various factors
can cause in-, at-, and out-of-the money
options to perform differently
before then. If the market has declined,
and your option has increased in value
to the extent that you want to take
your profits, you can always offset it
(sell) or exercise it. This may be to
your advantage if you are concerned
that the market will reverse direction,
and you will lose your gains prior to
Keep in mind, your option
can gain value without going into the
money. Increasing market volatility,
for example, can cause options to gain value. In that case, offset is the
Offset is also advisable in cases where the option is in
the money and retains considerable
time value. In that case, exercising the option captures
only the intrinsic value. Offset
Exercise is the obvious
choice when the option is deep in the
money, little or no time value remains,
and liquidity factors come into play.
Also, because options lose most of
their time value in their final month,
you may offset early to capture that
Example Situation: As a portfolio manager heavily invested in long-term notes, you
anticipate rising interest rates and declining note prices.
Objective: You want to protect the portfolio’s current market value while
retaining the opportunity to profit from a rally.
Strategy: Buy put options on 10-year Treasury note futures.
By purchasing put options, it is possible
to establish what amounts to a
“floor” for the value of the notes held
in your portfolio. The floor level
is determined by the strike price of the
options you purchase and the commissions and fees associated with the trade. In this case, the
higher the strike price, the higher the
option premium and floor level. On
the other hand, purchasing out-of-the money
puts provides less protection
at a lower cost.
If interest rates rise and note prices
decline, the gain realized from the put
option would offset the decrease in the
market value of the notes below whatever
floor price you have established.
As with any financial management
decision, your decision whether to buy
put options and the amount of protection
needed are judgement calls.
Obviously, the net portfolio return will be
reduced by the amount you paid for
the options and the commissions and fees associated withth hedge. In the end, your decision
to protect the portfolio with puts
should be influenced by your market
expectations and willingness to incur
the risk of a decline in portfolio value.
But keep in mind that the purchase of
put options does not preclude profit
from an increase in note prices. In this
case, your puts would expire, the
notes could be sold or held at their
higher market value, and the cost of
the options could be regarded as the
cost of having insurance.
To read more about hedging a portfolio, click here.