Introduction
In this article, we will learn about the concept of put options and how to use them in futures trading. A put option is one aspect of trading that forces the trader to sell a futures contract to the buyer at an agreed-upon price. A put option can provide protection to the trader from losses or can generate profits.
What is a Put Option?
Not all traders have the ability or desire to store and resell physical commodities. To take advantage of commodity markets, they trade futures options – derivative securities based on actual commodities traded on commodity exchanges. When futures contracts are made, traders can buy or sell options on them, betting that the price of the commodity will move in their favor. When a trader buys a put option, they are placing a contract on the other party in the investment at a specified price before the expiration date.
How to Buy the Right Option
When determining the put option you wish to purchase, you should consider the following factors:
Time Duration
If you expect the movement of the underlying commodity price to occur within two weeks, it’s preferable to buy put options that have at least two weeks remaining. Generally, investors avoid buying put options that expire within six to nine months if they plan to trade for a short period. The prices for these options are higher due to time value – their value based on the remaining duration before expiration. You should be aware that the time value of options deteriorates more quickly in the last 30 days. Therefore, you may be correct in the trade, but the option could lose much of its time value and you may end up with a loss.
The Amount You Can Allocate
Determining the amount of capital you can allocate to trading options can be challenging. A general rule for options traders is to not use more than 2 percent of their trading capital to buy an option. For instance, a put option for West Texas Intermediate (WTI) oil for May with a strike price of $60 may cost $1280. You could buy a put option and sell it for $1290 at the end of the day. Your profit would be $10, but if you want to buy more options, your profits (or losses) will multiply. According to the 2 percent rule, you would need to have $65,500 in your trading account to buy one put option. Multiply this by the number of options you wish to purchase, and you can see how much capital you will need to trade options.
Market Movement
Option prices move when the price of the underlying commodity changes. Commodity markets are volatile, as prices can change rapidly due to many factors. Current economic factors can cause commodity markets to move up or down. The way you trade the options depends on the market direction. A put option is a bet on a declining market, allowing the trader to profit from the change. You should plan your put options during trends where you are sure you will sell them for a higher price than what you bought them for.
Risk Level
Based on the size of your account and your risk tolerance level, some options may be too expensive for you to buy. “In the money” put options (where the strike price is higher than the market price) will be more expensive than “out of the money” options (where the strike price is lower than the market price). Unlike futures contracts, there is no margin when buying commodity options; you must pay the full value of the option upfront. Therefore, options in volatile markets like crude oil contracts can cost several thousand dollars. Even if you have the money, you wouldn’t want to buy deep out of the money options just because they are within your price range. Most deep out of the money put options (well below the market price) will expire worthless and are considered long shots.
Options
Selling Against Futures Contracts
Futures contracts – and thus options – are based on various assets or financial instruments, including interest rates, stock indices, currencies, energy, agricultural commodities, and metals. As with purchasing any options contracts, the potential losses when buying a put option are limited to the premium paid for the option, plus commissions and any fees. In contrast, you face the possibility of unlimited loss when buying a futures contract.
Conclusion
Buying a put option is a strategic step in futures trading. It can provide protection against losses and an opportunity for profit. However, you must consider several factors such as the duration, available funds, market movement, and risk level before choosing the right option. You should be aware that options lose their time value daily, and you need to be correct about the market direction and timing of the move.
Source: https://www.thebalancemoney.com/buying-a-put-option-809141
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