ptg From the Library of Melissa Wong ptg Commodity Options From the Library of Melissa Wong ptg This page intentionally left blank From the Library of Melissa Wong ptg Commodity Options Trading and Hedging Volatility in the World’s Most Lucrative Market Carley Garner and Paul Brittain From the Library of Melissa Wong ptg Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jim Boyd Editorial Assistant: Myesha Graham Operations Manager: Gina Kanouse Digital Marketing Manager: Julie Phifer Publicity Manager: Laura Czaja Assistant Marketing Manager: Megan Colvin Cover Designer: Alan Clements Managing Editor: Kristy Hart Project Editor: Chelsey Marti Copy Editor: Geneil Breeze Proofreader: Kathy Ruiz Indexer: Lisa Stumpf Senior Compositor: Gloria Schurick Manufacturing Buyer: Dan Uhrig ©2009 by Pearson Education, Inc. 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Library of Congress Cataloging-in-Publication Data Garner, Carley, 1977- Commodity options : trading and hedging volatility in the world’s most lucrative market / Carley Garner and Paul Brittain. p. cm. Includes index. ISBN 0-13-714286-2 (hardback : alk. paper) 1. Commodity options. I. Brittain, Paul. II. Title. HG6046.G37 2009 332.63’28—dc22 2008026048 From the Library of Melissa Wong ptg This book is dedicated to women in commodities From the Library of Melissa Wong ptg This page intentionally left blank From the Library of Melissa Wong ptg Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xix Chapter 1: Option Basics: A Crash Course in Option Mechanics . . . . . . . . . . . . . . . . . . . . . . . . .1 What Is an Option? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Intrinsic and Extrinsic Value: Components of an Option Price . . . . . . . . . . . . . . . . .3 Intrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Extrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Time Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Trading Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 The Art of Option Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Chapter 2: An Option Is an Option Is an Option…Think Again . . . . . . . . . . . . . . . . . . . . . . . . .11 Options on Futures, aka Options on Commodities . . . . . . . . . . . . . . . . . . . . . . . . .12 Differences in Underlying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Expiration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Nature of Market and Price Movement . . . . . . . . . . . . . . . . . . . . . . . . 19 Standardized Point Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Stock Splits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Difference in Option Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Number of Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Technology: Electronic Versus Open Outcry . . . . . . . . . . . . . . . . . . . . 23 From the Library of Melissa Wong ptg Independent Futures Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Different Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 LEAPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Quote Availability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Difference in Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Long-Term Versus Short-Term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Reporting Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Difference in Regulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 SEC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 NFA/CFTC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Difference in Trading Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28 The Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Black and Scholes Option Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34 Chapter 3: Long Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35 Why Long Options Aren’t Always a Great “Option” . . . . . . . . . . . . . . . . . . . . . . . . .35 When to Use Long Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 Alternative Uses of Long Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38 Factoring in Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Long Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40 When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Long Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42 When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Neutral Long Option Plays . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43 Long Straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44 When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 viii Trading Commodity Options From the Library of Melissa Wong ptg Contents ix Long Strangle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49 When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Conclusion of Long Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52 Chapter 4: Short Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53 Why Sell Options? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54 Theoretically Unlimited Risk: Option Selling Can Be Hazardous to Your Wealth! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55 Short Option Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56 The Premise Behind Option Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Preparing to Sell Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Technical Analysis and Option Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58 Option Selling Isn’t Always Appropriate . . . . . . . . . . . . . . . . . . . . . . . 58 Reverse Break-Even . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 The Execution of Option Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Exercise Me! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 The Art of Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61 The Double-Out Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Sell More Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Cover with a Futures Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Ratio Writes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Short Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64 When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 Short Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68 When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Option Selling Versus Trading Futures . . . . . . . . . . . . . . . . . . . . . . . . 70 Don’t Underestimate the Risk of Illiquid Markets . . . . . . . . . . . . . . . . 71 From the Library of Melissa Wong [...]... Trading Commodity Options In-the-Money (Intrinsic Value) At-the-Money Out-of-the-Money X Figure 1.1 The intrinsic value of a call option Put options are described in the following way (see Figure 1.2): ● In-the-money—The futures price is below the strike price ● At-the-money—The futures price equals the strike price ● Out-of-the-money—The futures price is above the strike price At-the-Money Out-of-the-Money... be in-the-money In-the-money and out-of-the-money are often falsely used It is important to know and understand the terminology by beginning traders Many traders refer to a profitable option involved in commodity trade as being in-the-money However, this is not the case An trading; this could help to option can be in-the-money and not profitable Likewise it can avoid costly mistakes be out-of-the-money... trade stemming from miscommunication between you and Call options are described in the following way your broker In-the-money (see Figure 1.1): Intrinsic value is what you would have if the option expiration was today ● In-the-money—The futures price is above the strike price ● At-the-money—The futures price is at the strike price ● Out-of-the-money—The futures price is below the strike price is a commonly... considerable amounts of risk can write (or sell) options, collecting the premium and taking advantage of the well-known belief that more options than not expire worthless The premium collected by a seller is seen as a liability until the option either is offset (by buying it back) or expires From the Library of Melissa Wong 2 Trading Commodity Options ● Call options Give the buyer the right, but not the... Trading Commodity Options is partly due to equity holders hedging their portfolios along with the expectation that markets drop faster than they go up You may have heard the concept of higher put valuation referred to in the context of a “volatility smile” or “skewed volatility.” In the case of equity indices the implied volatility of an atthe-money option is often less than that of an out-of-the-money... out than they would for an option that will most likely expire worthless As we cover in great detail throughout this book, the delta value of an at-the-money option is 50 and has roughly 50 percent odds of expiring in-the-money The Art of Option Trading In options trading the infamous adage “There is more than one way to skin a cat” holds true Many traders choose to ignore technical or charting tools... to challenge our perception Options on Futures, aka Options on Commodities As you have probably already realized, commodity options are written with a particular futures contract as the underlying If you recall, the underlying asset is one on which the value of the option is dependent Thus, just as a futures contract is a derivative (the value is derived from) of a physical commodity, an option is a... The Optionologist Visit www.CommodityOptionstheBook.com for additional information on the authors From the Library of Melissa Wong xix Introduction: An Unconventional but Effective Approach to Option Trading Many books have been written about options on futures, unfortunately we believe that many of them are either contradictory or just a meandering compilation of exchange-generated research and material... the United States The instruments that were being sold were “dealer granted” precious metal options, which were based on actual metal holdings of the option writer at the time of the contract origination In the mid-1980s, the various exchanges started introducing options on futures known as Exchange Traded Options or ETOs The explosion in this new trading vehicle was nothing short of breathtaking Based... markets to experience high demand of call options in a market Some traders look to be the that is in an uptrend and high demand of put options contrarians of the masses If in a downtrend Thus, it is not uncommon to see everyone else seems to be overpriced options in such scenarios An interesting buying the option, it may be phenomenon in the equity indices, put options are time to sell it almost always . publisher. Printed in the United States of America First Printing January 2009 ISBN-10: 0-1 3-7 1428 6-2 ISBN-13: 97 8-0 -1 3-7 1428 6-6 Pearson Education LTD. Pearson Education Australia PTY, Limited. Pearson. Ltd. Library of Congress Cataloging-in-Publication Data Garner, Carley, 197 7- Commodity options : trading and hedging volatility in the world’s most lucrative market / Carley Garner and Paul Brittain. p Paul Brittain. p. cm. Includes index. ISBN 0-1 3-7 1428 6-2 (hardback : alk. paper) 1. Commodity options. I. Brittain, Paul. II. Title. HG6046.G37 2009 332.63’28—dc22 2008026048 From the Library