Commodity and Futures Trading Options

What Are CME, NYMEX, COMEX, CBOT, ICE Commodity Markets and Futures Markets?

In the United States, trading futures began in the mid-19th century with the establishment of central grain markets where farmers could sell their products either for immediate delivery, also called the spot or cash market, or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner of today’s exchange-traded futures contracts. Both forward contracts and futures contracts are legal agreements to buy or sell an asset on a specific date or during a specific month. Where forward contracts are negotiated directly between a buyer and a seller and settlement terms may vary from contract to contract, a futures contract is facilitated through a futures exchange and is standardized according to quality, quantity, delivery time and place. The only remaining variable is price, which is discovered through an auction-like process that occurs on the Exchange trading floor or via CME Globex, CME Group’s electronic trading platform. Although trading began with floor trading of traditional agricultural commodities such as grains and livestock, exchange-traded futures have expanded to include metals, energy, currencies, equity indexes and interest rate products, all of which are also traded electronically.

Who Trades Futures and how to invest in commodities?

Conventionally, traders are divided into two main categories, hedgers and speculators. Hedgers use the futures market to manage price risk. Speculators on the other hand accept that risk in an attempt to profit from favorable price movement. While futures help hedgers manage their exposure to price risk, the market would not be possible without the participation of speculators. They provide the bulk of market liquidity, which allows the hedger to enter and exit the market in an efficient manner. Speculators may be full-time professional traders or individuals who occasionally trade. Some hold positions for months, while others rarely hold onto a trade more than a few seconds. Regardless of their approach, each market participant plays an important role in making the futures market an efficient place to conduct business.

Have a Trading Plan

Before you actually enter into a trade, develop a plan to guide your decision-making process. Your plan should be based on careful analysis of the markets you intend to trade. The following are some of the issues you will want to evaluate. What is your objective for the trade? To capitalize on an anticipated report, chart pattern or market indicator? To participate in a long-term trending market? How much risk is in the trade and how much risk are you willing to accept? If the trade turns against you, at what point will you liquidate the position? What types of orders will you use? Can you have protective stop-loss orders resting in place? How will you monitor market developments and price movements? Visit cmegroup.com/getting started for tutorials that may be useful in developing your trading plan.

Stick to Your Plan

As the saying goes, failing to plan is planning to fail. A key element that differentiates many successful traders from the unsuccessful traders is discipline. Successful traders have emotions like everyone else, but they do not let their emotions get in the way of making good trading decisions. For instance, when the market moves against a trader and passes through a previously established exit point, a good trader will exit the trade and accept the loss. This does not mean that the trader is happy about the loss, but he or she understands that having a good plan is only half the battle. The other half is sticking to it. You can sign up for a free trial of the Joss Report for additional reading material on this topic.

What is commodity trading and what is a Futures Contracts?

Futures markets trade futures contracts, which specify that the underlying index, currency, or commodity will be bought or sold for a specific price on a specific date in the future (known as the expiration date). Day traders trade futures contracts to make a profit on the difference between the buying price and the selling price, rather than to ever actually own the underlying commodity.

Commodity/Futures Options:

There are two types of options, calls and puts. A call gives the holder of the option the right, but not the obligation to buy the underlying futures contract. Conversely, the put gives the holder the right, but not the obligation to sell the underlying futures contract. Puts are usually bought when the expectation is for neutral or falling prices; a call is usually purchased when the expectation is for rising prices. The price at which an option is bought or sold is the premium.

Futures Options Buyers

Option buyers obtain the right, but not the obligation to enter the underlying futures market at a pre-determined price within a specified period of time. A "call" option confers the right to buy (go long) futures, while a "put" option confers the right to sell (go short) futures. The pre-determined price is known as the "strike" or "exercise" price, the last day when an option may be exercised is the "expiration date". Buyers pay sellers a premium for their option rights.

Because an option holder is under no obligation to enter the futures market, losses are strictly limited to the purchase value: there are no margin calls. If the underlying futures market moves against an option position, the holder can simply let the option expire worthless. On the opposite side, potential gains are unlimited, net of the premium cost. That feature allows hedgers to guard against adverse price movements at a known cost without foregoing the benefits of favorable price movements. In an options hedge, gains are only reduced by the premium paid - unlike futures hedge, where gains in the cash market are offset by futures market losses.

Option holders can exit their position in one of three ways: exercising the option and entering the futures market; selling the option back in the market; or simply letting the option expire worthless.

Futures Options Sellers

Option sellers, or "writers", receive a premium for granting option rights to buyers. In exchange for the premium, writers assume the risk of being assigned a position opposite that of the buyer in the underlying futures market at any time prior to expiration. Writers of call options must be prepared to assume short positions at the option's strike price at the option holder's discretion, while put option writers may be assigned long futures positions.

Writing put and call options can serve as a source of additional income during relatively flat market periods. Because option writers must be prepared to enter the futures market at any time upon exercise, they are required to maintain a margin account similar to that for futures. Sellers can offset their positions by buying back their option in the market.

Options Strike Price

Traders agree on premiums in an open outcry auction similar to that for futures contracts. The Exchange generally lists thirteen strike prices for each option month: one at or near the futures price, six above and six below. As futures prices rise or fall, higher or lower strike prices are introduced according to a present formula.

Option Premiums

A number of factors impact premium levels in the market. Chief among them is an option's intrinsic value. "Intrinsic value" is the dollars and cents difference between the option strike price and the current futures price. An option with intrinsic value has a strike price making it profitable to exercise and is said to be "in-the-money" (strikes below futures price for calls, above for puts). An option not profitable to exercise is "out-of-the-money" (strikes above futures prices for calls, below for puts). "At-the-money" options have strike prices at or very near futures prices. In general, an option's premium is at least equal to its intrinsic value (the amount by which it is "in-the-money").

"Time value" is the sum of money buyers are willing to pay for an option over and above any intrinsic value the option may presently have. Time value reflects a buyers' anticipation that, at some point prior to expiration, a change in the futures price will result in an increase in the option's value. The premium for an "out-of-the-money" option is entirely a reflection of its time value.

Premiums are also affected by volatility in the underlying futures market. Because high levels of volatility increase the probability that an option will become valuable to exercise, sellers command larger premiums when markets are more volatile. Finally, premiums are affected by supply and demand forces and interest rates relative to alternative investments.