How to Trade Options and Futures Contracts - dummies

How to Trade Options and Futures Contracts

By Michael Griffis, Lita Epstein

All types of options and futures are traded on a commodities exchange. In addition, some types of options can be traded on stock exchanges. There are two options. NYSEARCA Options trades stock options, index options, and options on exchange-traded funds based on a marker/taker price. The NYSE Alternext allows you to trade options on common stocks and American Depositary Receipts (ADRs) on a traditional pro-rata payment order flow.

The NASDAQ OMX trades options based on the MSCI Index, which tracks emerging markets; U.S. Treasuries; foreign currencies; and spot gold futures. The Chicago Board Options Exchange (CBOE) handles stock and several specialized futures options.

You can trade stock options and some index options in a traditional stock account. Special risk-release forms must be signed, but otherwise, the account remains the same. Naked short positions require a margin account.

How to open an account

If you want to buy futures or options on futures, you must do so through an individual account that you open with a registered futures commission merchant (FCM) or through your broker. Your broker transmits any transactions through an FCM as an introducing broker. Your broker won’t collect the funds from you for your options trades. You have to deposit them directly with the FCM.

You have the choice of opening either a discretionary account or a nondiscretionary account. A discretionary account is an account in which you sign a power of attorney over to either your FCM, your broker, or a commodity trading advisor (CTA) so he or she can make trading decisions on your behalf.

A nondiscretionary account is an account in which you make all the trading decisions. You also may want to consider trading through a commodity pool. When trading through a commodity pool, you purchase a share or interest in a pool of other investors, and trades are executed by an FCM or CTA. Any profits or losses are shared proportionately by the members of the pool.

When you open an individual account, you need to make a deposit that amounts to a margin payment or performance bond for the futures you trade. This payment is relatively small compared to the size of your potential market position, and it gives you the opportunity to greatly leverage your money. Small changes in options and futures prices can result in large gains or losses in short periods of time.

Your broker calculates the values of the futures and option contracts in your account on a daily basis, and you need to maintain a margin level that’s approximately 50 percent of the amount required when you originally enter your positions. If your holdings fall below that level, you’ll be asked to come up with the cash to restore your margin account to the initial level, in a margin call.

If you can’t meet the margin call in a reasonable period of time, which can be as little as an hour, your brokerage firm closes out enough of your positions to reduce your margin deficiency. If your positions are liquidated at a loss, you can be held liable for that loss, which sometimes can be substantially more than your original margin deposit.

How to calculate the price and make a buy

Before buying an option, you first must calculate the break-even price, but you must know the option’s strike price, the premium cost, and the commission or other transaction costs to be able to do it. With those three details in hand, you can determine a break-even price for a call option using this formula:

Option strike price + Option premium costs + Commission and transaction fees = Break-even price

Using the example in Table 19-1, here is the per-share break-even price for buying a May call option with a strike price of $54 and a commission of $25, or 25 cents per share:

$54 + $2.60 + $0.25 = $56.85

To make a profit on this call option, the stock price of ABC has to rise above $56.85. If the stock price doesn’t rise above $56.85, you won’t make a profit on this option purchase (unless you’re somehow able to sell the option for more than $2.85 before the expiration date).

These calculations are correct only when your broker has one fee for a round-trip option exchange. If you have to pay fees in both directions, which is common, then you need to double the fee in the calculation. Most brokers do charge fees in both directions. The fees are the same in each direction, so the cost for trading would be double.

When calculating the break-even price for a put option, you subtract the premium, commission, and transaction costs. Here is the break-even calculation for a May put option for ABC stock at a strike price of $54 with a commission of $25, or 25 cents per share:

$54 – $2.00 – 25 cents = $51.75

In this scenario, ABC stock has to drop below $51.75 for this put option to be worthwhile.

If you’re expecting a stock price increase, you want to consider purchasing a call option, but if you expect a price decline, you want to consider purchasing a put option. In both scenarios, you need to check the fundamental and technical analyses information you gathered on the underlying stock or asset so you can be certain that any break-even prices you’ve calculated reasonably match what your analysis indicates.