Part Three: The Mechanics of Buying and Writing Options

The first step: Calculate the Break-Even Price
Before purchasing any option, it's essential to precisely determine what the underlying futures price must be in order for the option to be profitable at expiration. The calculation isn't difficult. All you need to know to figure a given option's break-even price is the following:

• The option's price;
• The premium cost; and
• Commissions and other transaction costs.

Example: It's January and the 1,000 barrel April crude oil futures contract is currently trading at around $12.50 a barrel. Expecting a potentially significant increase in the futures price over the next several months, you decide to buy an April crude oil call option with a strike price of $13.00. Assume the premium for the option is $0.95 per barrel and that the commissions and other transaction costs are $50 which amounts to $0.05 a barrel.

Before investing, you need to know how much the April Crude Oil futures price must increase by expiration in order for the option to break even or yield a net profit after expenses. The answer is that the futures price must increase to $14 for you to break even and to above $14 for you to realize any profit.

Option strike price +	Premium +	Commission and transaction costs =	Breakeven price
$13.00	$0.95	$0.05	$14.00

The option will exactly break even if the April crude oil futures price at expiration is $14 a barrel. For each $1 a barrel the price is above $14.00, the option will yield a profit of $1,000.

If the futures price at expiration is $14 or less, there will be a loss. But in no even can the loss exceed the $1,000 total of the premium, commissions and transaction costs.

Determing the break-even price for a put option
The arithmetic is the same as for a call option except that instead of adding the premium, commission and transaction costs to the strike price, you subtract them.

Option Strike Price -

Option Premium -

Commission and Transaction costs =

Break-even price

Example: the price of hold is currently about $300 an ounce, but during the next few months you think there may be a sharp decline. To profit from the price decrease if you are right, you consider buying a put option with a strike price of $295 an ounce. The option would give you the right to sell a specified gold futures contract at $295 an ounce at any time prior to the expiration of the option.

Assume the premium for the put option is $3.70 per ounce ($370 in total) and the commission and transaction costs are $50 (equal to $0.50 an ounce).

For the option to break even at expiration, the futures price must decline to $290.80 an ounce or lower.

Option strike price -	Premium -	Commission and transaction costs =	Breakeven price
$295	$9.37	$0.50	$290.80

The option will exactly break even at expiration if the futures price is $290.80 an ounce. For each $1 an ounce the futures price is below $290.80 it will yield a profit of $100.

If the futures price at expiration is above $290.80, there will be a loss. But in no case can be loss exceed $420 - the sum of the premium ($370) plus commission and other transaction costs ($50).

Page Three

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 theNational Futures Association.