Questions to Ask before Trading Futures and Options
3 of 10 in Series: The Essentials of Futures and Options Trading
Before becoming a futures and options trader, you need to know what you're getting into — and what you may get out of the risk-taking experience. Look to this checklist for key questions that can help direct your research as you consider trading futures and options.
Are you trading a U.S. or a foreign option? And is it an exchange-traded or dealer-traded option? U.S. options are easily followed, and they’re regulated by the Commodity Futures Trading Commission and so are all the parties involved in issuing the contract. Exchange-traded options are standardized contracts that are more liquid and can be hedged better against risk. That isn’t always the case with other, dealer-traded options.
Who is guaranteeing the transaction? U.S. exchanges and firms are constantly monitored for liquidity and solvency. Foreign institutions are not necessarily as well monitored, so their futures and options contracts need to be checked individually, especially in the case of foreign options or options that are not exchange-traded.
How much of the premium that you pay is actually the value of the option? In some cases, the fees involved when you deal with independent options dealers can be very high and can hurt your transaction. Also keep the following in mind: commission versus cost of the option versus its theoretical value versus intrinsic value, all of which can be vastly different. You pay the option premium plus a commission charge; the commission is not imbedded in the option premium.
What is the break-even price for your option? In other words, how much price appreciation will be needed before you make money?
How much in commissions are you paying, and what kind of service are you getting for what you’re paying? Part of the answer here is to consider where you are with regard to your trade. Prior to expiration if long or short an option, your breakeven is the cost of your option. At expiration it gets a little more complicated. For calls, your breakeven is the strike price plus the premium paid or received by the writer. For puts, your breakeven is the strike price minus the premium paid or received by the writer.
Will your advisor/broker check several independent sources to find out what expectations are with respect to the future price of the underlying asset? If there is a widespread expectation that price will change very little in the future, the premium that you pay should be low.
How will you and your advisor/broker exercise your option, and what will you receive when you do? Always know how you and your broker will communicate. That means that you have to read and understand the terms of the management contract carefully before you put any money down.
How will your broker let you know when your options contract has been executed and what the status of your account is? Online brokers usually let you know this information automatically after your trade is executed. Some traditional brokers call you sometime after the order is executed. You have to do what is most comfortable for you.