Part Three: The Mechanics of Buying and Writing Options
Source: National Futures Association; published here with permission. This publication, Buying Options on Futures Contracts: A Guide to Uses and Risks,
is the property of the National Futures Association.
Commission Charges
Before you decide to buy and/or write (sell) options, you should understand the other costs involved in the transaction -
commissions and fees. Commission is the amount of money, per option purchased or written, that is paid to the brokerage
firm for its services, including the execution of the order on the trading floor of the exchange. The commission charge
increases the cost of purchasing an option and reduces the sum of money received from writing an option. In both cases,
the premium and the commission should be stated separately.
Each firm is free to set its own commission charges, but the charges must be fully disclosed in a manner that is not misleading.
In considering an option investment, you should be aware that:
- Commission can be charged on a per-trade or round-turn basis, covering both the purchase and sale.
- Commission charges can differ significantly from one brokerage firm to another.
- Some firms have a fixed commission charges (so much per option transaction) and other charge a percentage of the option
premium, usually subject to a certain minimum charge.
- Commission charges based on a percentage of the premium can be substantial, particularly if the option is one that has
a high premium.
- Commission charges can have a major impact on your changes of making a profit. A high commission charge reduces your
potential profit and increases your potential loss.
You should fully understand what a firm's commission charges will be and how they're calculated. If the charges seem high - either on
a dollar basis or as a percentage of the option premium - you might want to seek comparison quotes from one or two other firms. If a
firm seeks to justify an unusually high commission charge on the basis of its services or performance record, you might want to ask for
a detailed explanation or documentation in writing.
Leverage
Another concept you need to understand concerning options is the concept of leverage. The premium paid for an option is only
a small percentage of the value of the assets covered by the underlying futures contract. Therefore, even a small change in the
futures contract price can result in a much larger percentage profit - or a larger percentage loss - in relation to the premium. Consider
the following example:
an investor pays $200 for a 100-ounce gold call option with a strike price of $300 an ounce at a time when the gold futures price is $300
an ounce. If, at expiration, the futures price has risen to $303 (an increase of only one percent), the option value will increase by $300
(a gain of 150 percent on your original investment of $200).
But always remember that leverage is a two-edged sword. In the above example, unless the futures price at expiration had been above the option's
$300 strike price, the option would have expired worthless, and the investor would have lost 100 percent of his investment plus any commissions
and fees.
Page Two
Source: National Futures Association; published here with permission. This publication, Buying Options on Futures Contracts: A Guide to Uses and Risks,
is the property of the National Futures Association.
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