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Introduction To Options Trading

Common Strategies to Trading Options on Futures

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Table of Contents

Options Basics......................................................................................................................................... 4 Options Pricing. ........................................................................................................................................ 6 Reading Options Quotes......................................................................................................................... 8 Basic Options Trading Strategies........................................................................................................... 9 Quiz Yourself on Options. ...................................................................................................................... 11 More Information and Additional Resources....................................................................................... 15

Futures trading involves risk of loss. Trading advice is based on information taken from trades and statistical services and other sources which RJ OBrien believes are reliable. We do not guarantee that such information is accurate or complete and it should be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder. Past performance is not necessarily indicative of future trading results.

Introduction

Thank you for your interest in RJO Futures Introduction to Options Trading. Options offer several different ways for an investor to explore and take advantage of opportunties in price movements in commodities, foreign currencies, stocks, and interest rates through versatitly, leverage, limited risk, and hedging. Although the buyer of an option does have the advantage of a predetermined maximum risk (or premium), he or she is still risking 100% of an investment. Options are not suitable for all investors, and you should work with an RJO Futures Sr. Trading Advisor to determine if they are right for you. And as with any other speculative investment, the options investor should be aware of the risks and rewards before investing. This guide is only an introduction to options trading. It is not intended to be an all-inclusive manual to the many different strategies available in options trading. A more in-depth explanation of strategies can be found in our upcoming Choosing an Options Trading Strategy guide. Please keep an eye on www.rjofutures.com for more information on when the guide will be available. Regards, RJO Futures Sr. Trading Advisors Phone: 800-441-1616 or 312-373-5478 Email: info@rjofutures.com

Options Basics

History of Options
The standard definition of options is that they are contractual agreements that provide the right, but not the obligation, for the buying or selling of an underlying asset at a certain date at a set price. The premium is the price paid for that right. Initially, they were traded in an over-the-counter market, with each contract having unique terms. It was up to buyers and sellers to find each other, and they did so via newspaper ads. In the late 1960s, Joseph W. Sullivan, vice president of planning for the Chicago Board of Trade (CBOT) proposed standardizing strike price, expiration, size, and other contract terms. The CBOT established the Chicago Board Options Exchange and started trading listed call options on 16 stocks on April 26, 1973. Put trading was introduced in 1977. And although futures contracts have been traded on U.S. exchanges since 1865, options on futures contracts were not introduced until October 1982, when the Chicago Board of Trade began trading options on U.S. Treasury Bond futures.

Puts. These give the buyer the right, but not the obligation, to sell (go short) the underlying futures market at a stated price (the strike price), prior to option expiration. Generally speaking, if you think the asset price is going down, you would buy a put. And if you think the price is going up, you would buy a call. And there are basically three ways that options can be liquidated to make a profit or avoid loss: Exercising. By choosing to take delivery of (call) or sell (put) the underlying asset at the options strike price, a trader is exercising an option. Offsetting. This reverses the original transaction to exit the trade. In other words, a buyer of an option would sell it to liquidate, while the writer of an option would buy it back to liquidate. Expiration. If an option is not offset or exercised, it eventually expires. The buyer then loses the premium paid, while the writer profits by the premium paid (minus commissions and fees). Lets say you think gold is going to go up, and the September gold futures contract is $310 per ounce. You buy a call option with a strike price of $330. Gold futures control 100 ounces, and the call option is $5 per troy ounceso the premium you pay is therefore $500. You are considered the buyer or holder in the transaction and the entity you purchase the contract from is the writer. From there, your next move is affected by whether the price goes up or down.

What are Options?


There are two types of options: Calls. These give the holder the right, but not the obligation, to buy (go long) an asset at a certain price within a certain period of time.

If the Price Goes Up Now lets say the price of gold rises to $350. You can exercise the call (purchase the gold) at the $330 strike price, even though the price has increased. Your profit would be: The current futures price $350 Minus the strike price $330 $20 Minus the premium paid $5 per oz Profit $15 x 100 oz = $1,500

If the Price Goes Down Now lets say the price of gold falls to $300. You are under no further obligation, and you can simply let the option reach expiration. Your loss would be:

Premium paid

$5 per oz x 100 oz = $500

Retail traders tend to be more familiar with buying options, which lets you know the risk up front. But selling options can give you opportunities to profit even when the option expires worthless or decreases in valuewhich occurs most of the time. The chart at bottom takes a look at some of their other differences. Options are often used for as insurance against dropping prices, but they can also have other benefits. Leveraging power. Options allow you to fix the price, for a specific period of time, at which you can purchase the asset. And the premium paid is only a small percentage of the value of the underlying futures contractgiving options traders leverage. Risk management. Because they require less financial commitment, options can also be less risky.

Potential for higher returns. By the same token, since you are spending less and potentially making the same profit, you are getting a higher return on your investment. But such benefits dont mean that options are entirely without risk. You have to get direction, time frame, and amount of move right in order to profit.

Buying Options (Long) Profits are gained in option puts only in falling markets. Profits are gained in option calls only in rising markets. The maximum gain can be unlimited for bought calls. Maximum gain for bought puts can also be significant. The maximum potential loss for long options is all of the premiums that were paid.

Selling Options (Short) Profits can be gained by option puts sellers in flat to rising markets. Profits can be gained by option call sellers in flat to falling markets. The maximum gain is the total of the premiums received for selling short options.

The maximum loss can be unlimited, although margins can help contain them.

Options Pricing

First, lets review some previously discussed options terminology: Options, by definition, give buyers the option or right to buy or sell an underlying futures contractbut not the obligation. A call option gives the buyer the right to go long (buy) the underlying futures market at a stated price (the strike price), anytime prior to option expiration. And a put option gives the buyer the right to go short (sell) the underlying futures market at the strike price, anytime prior to option expiration. In addition to the type of option (put or call) and the current price of the underlying financial instrument, options premium pricing can be affected by the underlying futures markets relation to: Time value. This is the portion of the option premium attributable to the amount of time remaining until the expiration of the option contract. In general, the longer the amount of time until an options expiration, the greater the time value. Volatility. This is the amount of price movement in the underlying market over time. Prices that experience large swings up and/or down mean greater risk and potential rewardand therefore also mean a higher price on the option. Strike price. Also called the exercise price, this is the price at which the futures contract underlying a call can be exercisedand it is considered the biggest factor in determining the price of an option. Call options with a strike price below the current

price of underlying futures contracts are said to have intrinsic value. Put options with a strike price above the current price of the underlying futures contract also have intrinsic value. Intrinsic value is the difference between the underlying stocks price and the strike priceor the in-the-money portion of the options premium. So if a call options strike price is $25 and the underlying stocks market price is at $35, then the intrinsic value of the call option is $10. For a better understanding of intrinsic value, traders should look at what it means to be in the money, at the money, and out of the money. In the money. The Great Depression era song, Were in the Money is rumored to be a referral to this term, which means that options have achieved strike price. A call option is in the money if the strike price is below the price of the underlying futures. A put option is in the money if the strike price is above the price of the underlying futures. In-the-money options have positive intrinsic and time value. A September soybeans 600 call option is in the money if the underlying futures market is above 600. If the futures market is at 620, the option is in the money by 20 cents.

At the money. An option is at the money if the strike price is at the same price as the underlying futures, and only has time valueno intrinsic value. The same September soybeans 600 call option is at the money if the underlying futures market is at 600. Out of the money. Out of the money means an option would basically be worthless if it expired on the day in question. A call option is out of the money if the strike price is above the price of the underlying futures. A put option is out of the money if the strike price is below the price of the underlying futures. Out-of-the-money options also have no intrinsic value. The September soybeans 600 call option is out of the money if the underlying futures market is below 600. If the futures market is at 580, the option is out of the money by 20 cents.

For both the buyer and writer of a put, the breakeven point is also the same. And if the futures price is below break even, it means a profit for the buyer of a put option and a loss for the writer of the put option. Strike Price - Premium - Commission and Fees = Break Even

Call Option In the money At the money Out of the money Futures > Strike Futures = Strike Futures < Strike

Put Option Futures < Strike Futures = Strike Futures > Strike

Options traders also look at the break-even point in their trading. Break even is the price at which an options cost is equal to the proceeds acquired by exercising the option. For both the buyer and writer of a call, the break even is the same. And if the futures price is above break even, it means a profit for the buyer of the call option and a loss for the writer of the call option: Strike Price + Premium + Commission and Fees = Break Even

Reading Options Quotes

Following is an EXAMPLE of what a typical option quotes chart looks like, as well as how to read it:
1 2 3 Strike
9700 8500

4 Open
28750 10

5 High
28750 10

6 Low
28750 10

7 Last
28750 10

8 Chg
-180300 5

9 Prev. Settle
209050 5

10 Open Interest
1 162

11 DTE
25 25

Type Symbol
Call Put ES Q8C970 ES Q8P850

1. Type: Calls and Puts. These give the holder a right, but not the obligation to buy (go long) or sell (go short) the underlying futures market at a stated price (the strike price), prior to option expiration. 2. Symbol: This includes the symbol for the commodity, the symbol for the expiration month, and the strike price. 3. Strike: The strike price (or exercise price) of an option. 4. Open: The price that the option opened at on the trading day. 5. High: Shows the highest price that the options traded at on this day.

6. Low: Shows the lowest price that the options traded at on this day. 7. Last: The most recent trading price for the option updated online several times an hour and in the newspaper daily. 8. Chg (Change): Change in the price of the option, compared to the previous days closing price. 9. Previous Settle: The closing price of the contracts for the previous day. 11. DTE (Date Till Expiration): Number of days until the expiration of this option.

Basic Options Trading Strategies

Options can provide traders with a lot of flexibility, with strategy options available for bearish, bullish or neutral market environments. In addition to these basic strategies of long calls, long puts, short calls, and short puts, there are many other more complex ones to choose fromwhich you can read about in our Options Strategy Guide.

For each dollar that crude oil increases, the option buyers profit increases $1,000. As there is theoretically no limit to how high the price of crude oil can go, there is no limit to the profit that the buyer of the call option can make. Long Put October crude oil 110 put is currently trading at 3.50 ($350). The buyer of this put pays $3,500 (the premium) up front. This is his or her maximum risk. If October crude oil falls in price to 105, and the buyer of the option exercises the option, he or she takes a short position in the underlying futures from 110 (the strike price). Strike price Less futures price Less premium paid Profit 110.00 105.00 5.00 3.50 1.50 x $1,000 = $1,500

Option Buyer Strategies


The buyer of an option pays a premium up front to buy an option. This is his or her maximum risk. As for profit potential, it is unlimited for call option buyers and is limited only by the difference between the strike price and zero for put option buyers. Long Call October crude oil 145 call is currently trading at 1.50 ($1,500). The buyer of this call pays $1,500 (the premium) up front. This is his or her maximum risk. If October crude oil rises in price to 160, and the buyer of the option exercises the option, he takes a long position in the underlying futures from 145 (the strike price). With crude oil now at 160, profit is calculated as follows: Futures price Less strike price Less premium paid Profit 160.00 145.00 15.00 1.50 13.50 x $1,000 = $13,500

For each dollar that the price of crude oil drops, the option buyers profit increases $1,000. As the price of crude oil can go no lower than zero, the put buyers maximum profit is: Strike price Less futures price Less premium paid Profit 110.00 0 110.00 3.5.0 106.50 x $1,000 = $106,500

Option Writer Strategies


The writer (seller) of an option receives the premium up front to write an option, with this being his or her maximum profit potential. The writer of a call option has unlimited potential loss, while the writer of a put option has losses limited only by the difference between the strike price and zero. Short Call October crude oil 145 call is currently trading at 1.20 ($1,200). The writer of this call receives $1,200 (the premium) up front. This is his or her maximum profit potential. If October crude oil rises in price to $150, and the buyer of the option exercises the option, the writer is assigned a short position in the underlying futures from 145 (the strike price). With crude oil now at 150, his or her loss is calculated as follows: Futures price Less strike price Less premium recd. Loss 150.00 145.00 5.00 1.20 3.80 x $1,000 = $3,800

If October crude oil falls in price to $105, and the buyer of the option exercises the option, the writer is assigned a long position in the underlying futures from 110 (the strike price). With crude oil now at 105, his or her loss is calculated as follows: Strike price Less futures price Less premium recd. Loss 110.00 105.00 5.00 3.50 1.5 x $1,000 = $1,500

For each dollar that the price of crude oil drops, the option writers loss increases $1,000. As the price of crude oil can go no lower than zero, the put buyers maximum risk is: Strike price Less Futures price Less premium recd. Maximum risk 110 0 110 3.5 106.50 x $1,000 = $106,500

If you would like to learn more about options trading strategies or how you can get started, please feel free to contact an RJO Futures Sr. Trading Advisor for more information. They can be reached at (800) 441-1616 or (312) 373-5478.

For each dollar that crude oil increases, the option writers loss increases $1,000. As there is theoretically no limit to how high the price of crude oil can go, there is no limit to the loss that the writer of the call option can make. Short Put October crude oil 110 put is currently trading at 3.50 ($3,500). The writer (seller) of this put receives $3,500 (the premium) up front. This is his or her maximum profit potential.

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Quiz Yourself: Are You Ready to Advance to the Next Step or Do You Need to Review?
1.

An option means the buyer has the obligation to take a position in the underlying futures market.
a. True b. False

2.

Which of these gives the buyer the right to go short, or sell, the underlying futures market at a stated price, prior to option expiration?
a. b. c. d. Call Put Short None of the above

3.

How can you liquidate an option?


a. b. c. d. Expiration Exercised Offsetting trade All of the above

4.

Which of the following do you need to get right to profit in options?


a. b. c. d. Direction Time frame Amount of move All of the above

5.

The break-even point for both the buyer and writer of a call is the same.
a. True b. False

6.

Which of these describes when the strike price is at the same price as the underlying futures?
a. b. c. d. At the money In the money Out of the money None of the above

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7.

Which of these describes the predetermined price at which the buyer of an option has the right to take a position in the underlying futures?
a. b. c. d. Premium Strike price Margin None of the above

8.

A call option is in the money if the strike price is above the price of the underlying futures.
a. True b. False

9.

Which of these is a component of the price of an option?


a. Intrinsic value b. Time value c. Neither a nor b d. Both a and b

10. The break-even point for both the buyer and writer of a put is the same.
a. True b. False

11. In choosing an option strategy, consider whether you are:


a. b. c. d. Bullish Bearish Neutral All of the above

12. In reading options quotes, the symbol can consist of:


a. b. c. d. The symbol for the commodity The symbol for the expiration month The strike price All of the above

13. Which of these is the closing price of the contract for the previous day?
a. b. c. d. e. Last Chg Previous settle DTE None of the above

14. If you think an asset price is going up, you would secure which of these?
a. Put b. Call

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15. High volatility means higher options prices.


a. True b. False

16. How do you calculate the break-even point for both the writer and buyer of a call?
a. b. c. d. Strike price + premium commissions and fees = break even Strike price - premium commissions and fees = break even Strike price + premium + commissions and fees = break even None of the above

17. Which options strategy is created by being long in one call and two put options, all with the exact same strike price?
a. b. c. d. Strangle Straddle Spread None of the above

18. In which options strategy does the investor hold a position in both a call and put, with different strike prices but with the same maturity and underlying asset?
a. b. c. d. Strangle Straddle Spread None of the above

19. Which options strategy is established by purchasing one option and selling another option of the same class but of a different series?
a. b. c. d. Strangle Straddle Spread None of the above

20. In which options strategy does the investor hold a position in both a call and put with the same strike price and expiration date?

Answers and scoring on following page.

a. b. c. d.

Strangle Straddle Spread None of the above

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Answers
1 (b), 2 (b), 3 (d), 4 (d), 5 (a), 6 (a), 7 (b), 8 (b), 9 (d), 10 (a), 11 (d), 12 (d), 13 (c), 14 (b), 15 (a), 16 (c), 17 (d), 18 (a), 19 (c), 20 (b) Each correct answer equals 1 point. My Score: _______

Scoring (out of 20 possible points)


17-20 = You Understand Options Basics Contact an RJO Futures representative at 800-441-1616 now, and learn how you can turn your new knowledge into possible trading opportunities. We can help.

12-16 = You May Want to Revisit the Material Youve learned a fair amount about options basics. But we recommend you revisit the material to fully grasp the concepts. Once you have it down, you may be ready to apply what youve learned to your trading.

1-11 = Definitely Revisit the Material, and Take the Quiz Again. No worries. You simply need to reread the material and/or contact an RJO Futures Trading Consultant at 800-441-1616 for assistance. Well be happy to walk you through any parts of this guide to help you to better understand the content. And we offer many other resources to help you along the way.

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Get More Information About Options


Next Steps
We invite you to contact our Trading Team here at RJO Futures. They will be able to walk you through some of the principles detailed in this guide as well as take you to the next level in your understanding of Options.

Contact us at
Phone: (800) 441-1616 or (312) 373-5478 Email: info@rjofutures.com Web: www.rjofutures.com

Additional Resources
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RJO Futures Intro to Fundamental Analysis


Now that youve got a primer on options strategy, why not give our Intro to Fundamental Analysis guide a try? This proprietary guide provides information on which related economic, financial, and other qualitative and quantitative factors can be used to evaluate commodities in the agriculturals, softs, metals, and energies markets. Contact an RJO Futures trading consultant at (800) 441-1616 or (312) 373-5478 to get your free copy today.

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