Part Three: The Mechanics of Buying and Writing Options

Factors Affecting the Choice of an Option
If you expect a price increase, you'll want to consider the purchase of a call option. If you expect a price decline, you'll want to consider the purchase of a put option. However, in addition to price expectations, there are two other factors that affect the choice of option:

• The length of the option; and
• The option strike price

The length of the option
One of the attractive features of options it hat they allow time for your price expectations to be realize. the more time you allow, the greater the likelihood the option will eventually become profitable. This could influence your decision about whether to buy, for example, an option on March futures contract or an option on a June futures contract.

Bear in mind that the length of an option (such as whether it has three months to expiration or six months) is an important variable affecting the cost of the option. A longer option commands a higher premium.

The option strike price
The relationship between the strike price of an option and the current price of the underlying futures contract is, along with the length of the option, a major factor affecting the option premium. At any given time, there may be trading in options with a half dozen or more strike price - some of them below the current price of the underlying futures contract and some of them above.

A call option with a low strike price will have a higher premium cost than a call option with a higher strike price because it will more likely and more quickly become worthwhile to exercise. For example, the right to buy a crude oil futures contract at $11 a barrel is more valuable than the right to buy a crude oil futures contract at $12 a barrel.

conversely, a put option with a high exercise price will have a higher premium cost than a put option with a low exercise price. For example, the right to sell a crude oil futures contract at $12 a barrel is more valuable than the right to sell a crude oil futures contract at $11 a barrel.

While the choice of a call option or put option will be dictated by your price expectations, and you choice of expiration month by when you look for the expected price change to occur, the choice of strike price is somewhat more complex. That's because the strike price will influence not only the option's premium cost by also how the value of the option, once purchased, is likely to respond to subsequent changes in the underlying futures contract price. Specifically, options that are out-of-the-money do not normally respond to changes in the underlying futures price the same as options that are at-the-money or in-the-money.

Generally speaking, premiums for out-of-the-money options do not reflect, on a dollar for dollar basis, changes in the underlying futures price. The change in option value is usually less. Indeed, a change in the underlying futures price could have little effect, or even no effect at all, on the value of the options. This could be the case if, for instance, the option remains deeply out-of-the-money after the price change or if expiration is near.

Page Four

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.