Introduction to derivatives Futures and Options

This article introduces the concept of derivatives and explains their utility. It also explains futures and options in detail.

What is a derivative?
The textbook definition of a derivative is: A derivative is an instrument whose value depends on an underlying.
What does it mean in simple terms? Well, the word is kind of self explanatory the value of a derivative
is derived from the value of something. This something is called the Underlying of the derivative.
So, for stock derivatives, the price of the shares of a particular company is the underlying. For an index derivative, the
value of the index is the underlying. And for a crude oil derivative, the price of crude oil is the underlying.
As and when the price of the underlying changes, the value of the derivative based on it also changes. Of course, the
price also depends on the demand and supply for that derivative, but the primary driver of the price of a derivative is
the price of the underlying.

Various Underlying Assets

Markets are very creative! There are people everywhere who spot opportunity to earn money from innovative sources,
and therefore, derivatives are available for almost anything!
The primary focus of this article would be derivatives based on equities and equity indices. But the other derivatives
available are: Commodity derivatives (crude oil, cotton, etc), bullion derivatives (gold, silver, etc), weather derivatives,
and many more.

Types of Derivatives
There are many types of derivatives, but let me talk about the two basic derivatives traded in India.
Futures
This is a derivative contract in which the quantity, rate and date of a future purchase is agreed upon today for a given
asset.
At this pre-decided date, the buyer of the futures contract gets the delivery of the pre-decided quantity of the given
asset at the pre-decided price. Similarly, the seller of the futures contract gives the delivery of the pre-decided quantity
of the given asset at the pre-decided price.
In a futures contract, both the buyer and seller are bound to honour their commitment the buyer has to take delivery,
and the seller has to make delivery according to the terms of the contract.
Thus, even if the price of the asset goes down, the buyer has to get the asset from the seller at the pre-decided price.
And even if the price goes up, the seller has to give the seller at the pre-decided price.
Cost
There is no upfront cost involved in the purchase of a futures contract, apart from brokerage.
Example
A sells the futures contract of Reliance Industries stock to B. Quantity is 200 shares, price is Rs. 3200 and the expiry
date is 3 months away.
Now, after 3 months, irrespective of the market price of the stock of Reliance Industries, A would deliver 200 shares of
Reliance Industries to B at Rs. 3200.

Options
As the name suggests, here, the buyer has an option to take delivery of the asset, and not the obligation. Thus, if the
market price of the asset goes up, and buyer of an option would exercise the option and get profits. But if the market
price of the asset goes down, the buyer of the option would not exercise it, and would allow the option to lapse.
Thus, Options are more flexible for the buyers compared to futures. But the seller of the option has the obligation to
deliver the assets if the buyer chooses to exercise the option.
In case of options, the pre-decided price for the exchange of asset is called the Strike Price.
One thing to remember though is that in reality, not many people actually exercise their options people do not
actually exchange the asset at the time of exercise. Since the options are traded in the market, instead of exercising
them, the buyers just sell them in the market.
The logic behind this when an option is in the money (that is, when it becomes profitable for the buyer), its option
premium or the price goes up. So, one can sell it and make profit instead of exercising it. This is easier, and therefore
is done by most people.
American and European Options
The options are of two types American and European. In American options, the option can be exercised any time
upto the settlement date. In European options, the option can be exercised only on the settlement date. Thus,
American options are much more flexible (I am introducing this here just as a concept in India, only American
options are traded).
Cost
There is a cost involved for options the buyer of the option has to pay the seller an Option Premium, which is the
fee the option seller (also called the Option Writer) gets in return for the one-sided guarantee he extends to the buyer.
Since the option writer assumes the risk of the price movement, this fee is well justified.
Example
A writes the option of Reliance Industries stock to B. Quantity is 200 shares, strike price is Rs. 3200 and the expiry
date is 3 months away. The option premium is Rs. 25.
Now, during these 3 months, say the price of Reliance Industries stock goes up to Rs. 3400. In this case, B would
exercise the option, and would get the shares at Rs. 3200 from A.
Thus, B would make a profit of Rs. 3400 Rs. 3200 Rs. 25 (Option premium) = Rs. 175. Similarly, A would make a
loss of Rs. 175.
But if the price of Reliance Industries stock remains less than Rs. 3200 for the 3 month duration, B would not exercise
the option. In this case, the option buyer B would make a loss equal to the option premium Rs. 25 in this case, and
the option writer would make a profit equal to the option premium Rs. 25.

Use of Derivatives
The primary use of a derivative is to hedge risk (also called Hedging). When you buy a derivative, you are making a
provision that makes your cash flows more certain, or that limits your losses. (I would write another article to illustrate
this using calculations).
For example, say you are an exporter, and your earnings are in dollars. Now, you would receive your payment of
$15000 after six months. But since you spend in Rupees, you would also like to keep track of your earnings in
Rupees.

The value of dollars after six months would decide your actual earning in rupees. Since that is not known right now, it
brings uncertainty to your earnings too. Derivatives can be helpful in such a scenario.
You can buy Dollar Rupee futures contract of $15000 with the rate of Rs. 39.5 for a dollar, and with a validity of 6
months. Thus, you would be certain about your earnings after 6 months whether the rate after 6 months is Rs. 37 or
Rs. 41, you would get Rs. 39.5 for every dollar.
For a business, this kind of certainty in cash flows and earnings can be a very big relief!
Hedging is the primary use of derivatives. But in the market, apart from hedgers, we also have many participants that
use derivatives just for investments people who want to make profits out of the price movement of derivatives just
like stocks.
The presence of such participants is not bad, because they provide liquidity and depth to the derivatives market.

What is Futures Trading?

Futures Trading is a form of investment which involves speculating on the price of a commodity going up or down
in the future.
What is a commodity? Most commodities you see and use every day of your life:

the corn in your morning cereal which you have for breakfast,

the lumber that makes your breakfast-table and chairs

the gold on your watch and jewellery,

the cotton that makes your clothes,

the steel which makes your motor car and the crude oil which runs it and takes you to work,

the wheat that makes the bread in your lunchtime sandwiches

the beef and potatoes you eat for lunch,

the currency you use to buy all these things...

... All these commodities (and dozens more) are traded between hundreds-of-thousands of investors, every day, all
over the world. They are all trying to make a profit by buying a commodity at a low price and selling at a higher price.
Futures trading is mainly speculative 'paper' investing, i.e. it is rare for the investors to actually hold the physical
commodity, just a piece of paper known as a futures contract.

What is a Futures Contract?

To the uninitiated, the term contract can be a little off-putting but it is mainly used because, like a contract, a futures
investment has an expiration date. You don't have to hold the contract until it expires. You can cancel it anytime
you like. In fact, many short-term traders only hold their contracts for a few hours - or even minutes!
The expiration dates vary between commodities, and you have to choose which contract fits your market objective.
For example, today is June 30th and you think Gold will rise in price until mid-August. The Gold contracts available are
February, April, June, August, October and December. As it is the end of June and this contract has already expired,
you would probably choose the August or October Gold contract.

The nearer (to expiration) contracts are usually more liquid, i.e. there are more traders trading them. Therefore, prices
are more true and less likely to jump from one extreme to the other. But if you thought the price of gold would rise until
September, you would choose a further-out contract (October in this case) - a September contract doesn't exist.
Neither is their a limit on the number of contracts you can trade (within reason - there must be enough buyers or
sellers to trade with you.) Many larger traders/investment companies/banks, etc. may trade thousands of contracts at
a time!
All futures contracts are standardised in that they all hold a specified amount and quality of a commodity. For
example, a Pork Bellies futures contract (PB) holds 40,000lbs of pork bellies of a certain size; a Gold futures contract
(GC) holds 100 troy ounces of 24 carat gold; and a Crude Oil futures contract holds 1000 barrels of crude oil of a
certain quality.

A Short History of Futures Trading

Before Futures Trading came about, any producer of a commodity (e.g. a farmer growing wheat or corn) found himself
at the mercy of a dealer when it came to selling his product. The system needed to be legalised in order that a
specified amount and quality of product could be traded between producers and dealers at a specified date.
Contracts were drawn up between the two parties specifying a certain amount and quality of a commodity that would
be delivered in a particular month...
...Futures trading had begun!
In 1878, a central dealing facility was opened in Chicago, USA where farmers and dealers could deal in spot grain,
i.e., immediately deliver their wheat crop for a cash settlement. Futures trading evolved as farmers and dealers
committed to buying and selling future exchanges of the commodity. For example, a dealer would agree to buy 5,000
bushels of a specified quality of wheat from the farmer in June the following year, for a specified price. The farmer
knew how much he would be paid in advance, and the dealer knew his costs.
Until twenty years ago, futures markets consisted of only a few farm products, but now they have been joined by a
huge number of tradable commodities. As well as metals like gold, silver and platinum; livestock like pork bellies and
cattle; energies like crude oil and natural gas; foodstuffs like coffee and orange juice; and industrials like lumber and
cotton, modern futures markets include a wide range of interest-rate instruments, currencies, stocks and other indices
such as the Dow Jones, Nasdaq and S&P 500.

Who Trades Futures?

It didn't take long for businessmen to realise the lucrative investment opportunities available in these markets.
They didn't have to buy or sell the ACTUAL commodity (wheat or corn, etc.), just the paper-contract that held the
commodity. As long as they exited the contract before the delivery date, the investment would be purely a paper one.
This was the start of futures trading speculation and investment, and today, around 97% of futures trading is done by
speculators.
There are two main types of Futures trader: 'hedgers' and 'speculators'.
A hedger is a producer of the commodity (e.g. a farmer, an oil company, a mining company) who trades a futures
contract to protect himself from future price changes in his product.
For example, if a farmer thinks the price of wheat is going to fall by harvest time, he can sell a futures contract in
wheat. (You can enter a trade by selling a futures contract first, and then exit the trade later by buying it.) That way, if
the cash price of wheat does fall by harvest time, costing the farmer money, he will make back the cash-loss by
profiting on the short-sale of the futures contract. He sold at a high price and exited the contract by buying at a
lower price a few months later, therefore making a profit on the futures trade.

Other hedgers of futures contracts include banks, insurance companies and pension fund companies who use futures
to hedge against any fluctuations in the cash price of their products at future dates.
Speculators include independent floor traders and private investors. Usually, they dont have any connection with the
cash commodity and simply try to (a) make a profit buying a futures contract they expect to rise in price or (b) sell a
futures contract they expect tofall in price.
In other words, they invest in futures in the same way they might invest in stocks and shares - by buying at a low
price and selling at a higher price.

The Advantages of Trading Futures

Trading futures contracts have several advantages over other investments:
1. Futures are highly leveraged investments. To own a futures contract an investor only has to put up a small
fraction of the value of the contract (usually around 10%) as margin. In other words, the investor can trade a much
larger amount of the commodity than if he bought it outright, so if he has predicted the market movement
correctly, his profits will be multiplied (ten-fold on a 10% deposit). This is an excellent return compared to buying a
physical commodity like gold bars, coins or mining stocks.
The margin required to hold a futures contract is not a down payment but a form of security bond. If the market goes
against the trader's position, he may lose some, all, or possibly more than the margin he has put up. But if the market
goes with the trader's position, he makes a profit and he gets his margin back.
For example, say you believe gold in undervalued and you think prices will rise. You have $3000 to invest - enough to
purchase:

10 ounces of gold (at $300/ounce),

or 100 shares in a mining company (priced at $30 each),

or enough margin to cover 2 futures contracts. (Each Gold futures contract holds 100 ounces of gold, which is
effectively what you 'own' and are speculating with. One-hundred ounces multiplied by three-hundred dollars
equals a value of $30,000 per contract. You have enough to cover two contracts and therefore speculate with
$60,000 of gold!)

Two months later, gold has rocketed 20%. Your 10 ounces of gold and your company shares would now be worth
$3600 - a $600 profit; 20% of $3000. But your futures contracts are now worth a staggering $72,000 - 20% up on
$60,000.
Instead of a measly $600 profit, you've made a massive $12,000 profit!
2. Speculating with futures contracts is basically a paper investment. You dont have to literally store 3 tons of gold in
your garden shed, 15,000 litres of orange juice in your driveway, or have 500 live hogs running around your back
garden!
The actual commodity being traded in the contract is only exchanged on the rare occasions when delivery of the
contract takes place (i.e. between producers and dealers the 'hedgers' mentioned earlier on). In the case of a
speculator (such as yourself), a futures trade is purely a paper transaction and the term 'contract' is only used mainly
because of the expiration date being similar to a contract.
3. An investor can make money more quickly on a futures trade. Firstly, because he is trading with around tentimes as much of the commodity secured with his margin, and secondly, because futures markets tend to move more
quickly than cash markets. (Similarly, an investor can lose money more quickly if his judgement is incorrect, although
losses can be minimised with Stop-Loss Orders. My trading method specialises in placing stop-loss orders to
maximum effect.)

4. Futures trading markets are usually fairer than other markets (like stocks and shares) because it is harder to
get inside information. The open out-cry trading pits -- lots of men in yellow jackets waving their hands in the air
shouting "Buy! Buy!" or "Sell! Sell!" -- offers a very public, efficient market place. Also, any official market reports are
released at the end of a trading session so everyone has a chance to take them into account before trading begins
again the following day.
5. Most futures markets are very liquid, i.e. there are huge amounts of contracts traded every day. This ensures
that market orders can be placed very quickly as there are always buyers and sellers of a commodity. For this reason,
it is unusual for prices to suddenly jump to a completely different level, especially on the nearer contracts (those which
will expire in the next few weeks or months).
6. Commission charges are small compared to other investments and are paid after the position has ended.
Commissions vary widely depending on the level of service given by the broker. Online trading commissions can be as
low as $5 per side. Full service brokers who can advise on positions can be around $40-$50 per trade. Managed
trading commissions, where a broker controls entering and exiting positions at his discretion, can be up to $200 per
trade.

Why Leverage is the Biggest Advantage and the Biggest Disadvantage

The main advantage and disadvantage in futures trading is the leverage involved. (You can hold a very large amount
of a commodity for a small deposit so any gains and losses are multiplied.) This is the main difference between futures
trading and, say, speculating with stocks and shares.
For example, you have $3000 to invest. You could buy $3000 of shares in an Oil Mining Company, buying them
outright. Or this $3000 may be sufficient margin (a goodwill "security bond") to buy a couple of Crude Oil futures
contracts worth $30,000.
The price of Crude Oil drops 10%. If this effects the price of your mining stocks by 10%, you would lose $300 (10% of
$3000). But this 10% fall on the value of your Crude Oil futures contracts would lose $3000 (10% of $30,000). In other
words, all of your initial stake would be lost trading the futures rather than only 10% of your capital trading the shares.
But, with Stop-Loss Orders you will always know how much money you are risking in any trade.
A Stop Loss Order is a pre-determined exiting point which automatically exits your position should the market go
against you. In the above example, you may only decide to risk $1000 on the Crude Oil futures contracts. You would
place a stop loss just under the market price and if the market dropped slightly, your position would be exited for the
$1000 loss.
So Leverage is great if the market goes in your predicted direction - you could quickly double, treble or quadruple
your initial stake. But if the market goes against you, you could lose a lot of money just as quickly. All of your initial
stake (your margin) could be wiped out in a few days. And in some cases, you may have to pay more money to your
broker if the margin you have put up is less than the loss of your trade.

How to Protect Profits with Stop-Loss Orders

As mentioned above, losses can accumulate just as quickly as profits in futures trading. Nearly every successful
trader uses Stop-Loss Orders in his trading to ensure profits are 'locked in' and losses are minimised.
How do Stop-Losses work?
A stop-loss is usually placed when a trade is entered, although it can be entered or moved at any time. It is placed
slightly below or above the current market price, depending on whether you are buying or selling.

For example, say Pork Bellies is trading at $55.00 and you think prices are about to rise. You decide to buy one Pork
Bellies contract, but you don't want to risk more than $800 on the trade. A one-cent move in the market is worth $4.00
on a pork bellies futures contract so, therefore, you would place your stop at $53.00 (200 cents away from the current
price x $4 per point = $800).
You can also move a stop-loss order to protect any profits you accumulate.
Taking the Pork Bellies example: Two weeks later, bellies are now trading at $65.00. You are now up $4000 (1000
cents of movement x $4). To protect these profits, you can raise your stop-loss simply by calling your broker. Say you
place it at $63.00, you have locked it a profit of at least $3200 and now risk $800 to your new stop level.
But what if the market went against you? Going back to the original position when you bought at $55.00 with a stop at
$53.00: what happens if the market suddenly tumbles down to $51.00 during the day? Your trade would automatically
be 'stopped out' at your stop level of $53.00 for an $800 loss. The fact that the market closed the day at $51.00 is
irrelevant as you are now out of the market. (Had you not used a stop-loss and viewed the market at the end of the
day, you would have large losses on your hands!)
The same would happen if the market reached $65.00 and you had raised your stop to $63.00: If the market fell from
here, say to $62.80, you would be stopped out at $63.00 and would have a profit of $3200. Even if the market
suddenly reversed here and rose to $79.00, this would be irrelevant as you are now out of the market.
This last example would be annoying because if you hadn't been stopped out, you would now be $9600 in profit. But
you were stopped out at your $63.00 stop. The market only went 20-cents under this and reversed!
It is for this reason that some traders don't use stops: they have been stopped out in the past JUST when the market
was about to go their way.
The solution is not to abandon using stops as this is EXTREMELY RISKY. The solution is to use stops effectively.
(In fast moving markets it is sometimes impossible for brokers to get your orders exited exactly on your stop loss
limits. They are legally required to do their best, but if the price in the trading pit suddenly jumps over your limit, you
may be required to settle the difference. In the above scenario, the price of Pork Bellies could open trading at $62.50,
fifty cents through your stop at $63.00. Your broker would have to exit your trade here and, in fact, you would lose
$1000, $200 more than your anticipated $800.)

Where to Get Market Information

Commodity prices can change direction much faster than other investments, such as company stocks. Therefore, it is
important for traders to stay on top of market announcements. Professional traders may use a wide number of
techniques to do this, using fundamental information and technical indicators.
Fundamental data may include government reports of weather, crop sizes, livestock numbers, producers figures,
money supply and interest rates. Other fundamental news that could affect a commodity might be news of an outbreak
of war.
Technical indicators are mathematical tools used to plot market prices and behaviour patterns on a graph. These
can include trend lines, over-bought and over-sold indicators, moving averages, momentum indicators, Elliott wave
analysis and Gann theory.
Some traders use just one of these basic methods religiously, disregarding the other completely. Others use a
combination of the two.
Many investors, especially smaller investors, devise their own trading method or purchase one from another trader.
(Be careful not to buy a system that has been over-optimised and curve-fitted to fit past data. Many times, I have seen

systems claiming 80%+ winning trades on past data, but when I have run the system on current prices, the results are
breakeven at best!)
They normally paper trade the method (i.e. they follow the markets but only pretend to place the trades) for a few
months to make sure the method works for them before placing any actual trades.
Tracking price charts and keeping up with fundamental data is a difficult full-time job some large organisations
employ dozens of staff to follow market moves. And some traders, especially those on the market floor, may only hold
a position for a few hours or even minutes.
So where does this leave the small, independent investor who would like to trade in the lucrative futures markets?
Many trade on a daily or weekly basis, i.e. they note or 'download' market prices at the end of each trading day and
make their decisions from this data. Often, they will leave a trade on for at least a few weeks (possibly months). This is
a much SAFER way of trading because any fluctuations are ridden out and less panic-buying or selling is involved.

Futures Contracts for Beginners

If you have a limited amount of capital to invest, you probably can't afford to trade the larger contracts like the Nasdaq
and S&P500 as a slight percentage move could be worth thousands of dollars. But there are still plenty of smaller
and less expensive contracts you can trade.
All futures contracts have standardised amounts of the commodity which are held by them. For example, if you buy a
single pork bellies contract, you are holding the value of 40,000lbs of pork bellies. If you sell a single soybeans
contract you are betting on the value of 5000 bushels of soybeans.
Each point-move on a particular contract is worth a specific amount, and these amounts vary between contracts. For
example, a 1-cent move on a Pork Bellies contract is worth $4, so a move in the market from $60.00 to $61.50 would
be worth $600 per contract ($4 x 150 cents). In Soybeans, a 1-cent move in the market is worth $50 so a jump from
$500 to $505 is worth $250 ($50 x 5c).
Some contracts are worth a lot more than others, especially if they are trading at historically high prices. For
example, at the time of writing, the Nasdaq Index moved up around 10% last month worth nearly $50,000 per
contract! (It is at an all time high, 20 times higher than 10 years ago.) But Wheat dropped around 10% per contract worth about $1250 per contract. (It is at its lowest price for years.)
Beginners need to first establish if they can afford to trade the commodity - if they have enough margin in their account
to cover the trade, and if they can afford a sizeable move against their position. (Some traders such as Larry Williams
and Tom Basso feel that risking approximately 3% to 5% of total trading capital on a position is about right. Remember
too, that these traders are some of the best in the world - if you are a beginning trader, you should be careful risking
that much!) Your broker will probably give you a list of dollar-per-point ratios for all the different contracts, as well as
their commission and margin requirements.
A trader also needs to establish the risk/reward of trading on any particular commodity - how much you are risking to
your stop loss and how much you intend to win to your target price. (Alternatively, work out the average loss and profit
made by your trading system to find the expectancy of a trade's profits.)
It is also important for traders to spread the risk of trading by using different types of commodity. For example, just
because you have enough capital to trade 5 contracts, don't buy five energy contracts just because they have the
largest risk/reward ratio. Instead, spread your risk by trading some grains, some metal, some energy, some livestock
and some currency (if they are potentially rewarding).
You may also buy or sell more than one contract on each commodity to keep the risk balanced. For example, a Pork
Bellies contract may be worth a lot more than a Soybeans contract. You may decide to buy two Pork Bellies contracts
and six Soybeans contracts to keep the values held on each market about equal.

None of your trades should risk more than 5% of your trading capital if possible. (And in "trading capital", I mean
money you can afford to, and are prepared to LOSE!) That way, you would have to lose 20 trades in a row in order to
get wiped out.

Futures Trading Alternatives

Speculating on the commodity markets can certainly be an excellent form of investment. But it can require a large
amount of capital to speculate effectively on the futures markets. To set up the smallest futures account normally
requires at least $5000, and many brokers require proof that you can afford to pay any losses greater than the funds in
your account. (In case the market suddenly drops below your stop-loss level.)
Also, even the smallest futures contracts require at least $1000-$3000 in margin for you to hold them. This means a
speculator with a $5000 account may only be able to trade one or two markets at a time. Many top traders
recommend spreading your risk between several markets at a time. And, as mentioned above, you should only risk up
to 5% of your trading capital on any position.
So if you haven't got $20,000 or $100,000 to speculate with, what are your options?

Smaller Futures Contracts

Most of the widely traded futures contracts are large contracts traded on the Chicago Board of Trade, The Chicago
Mercantile Exchange or the New York Mercantile Exchange. But there are also other exchanges that trade much
smaller futures contracts.
For example, the MIDAM exchange (Mid-America) trades most of the major commodity and currency markets but
under smaller contracts. Typically they hold one-fifth to one-half the amount of the commodity of the more popular
contracts meaning the risks and margin requirements are a lot less.
Other exchanges around the world trade smaller futures contracts of various commodities, such as Brent Crude Oil on
the LPE, London Wheat on LIFFE, and Copper, Aluminium and Tin on the LME.

Spread Betting
Spread betting is a relatively new approach of trading the futures markets. A spread betting company, such as IG
Index, Financial Spreads, or City Index doesnt charge a commission but gets paid on a spread of the market price.
This is usually a couple of points either side of the actual market price, like an ask/bid spread.
For example, say the March Gold contract is trading at $300 per ounce. Depending on which way you wanted to trade,
you may be quoted 298/302.
If you were buying you would enter at $302 two points above the market price.
If you wanted to sell, you would enter at $298 - two points under the market price.
Both the spreads go against your market direction. If the value of one point on the contract was $100, in effect you
would be paying a 2 point spread worth $200.
This is quite a lot more expensive than a normal futures brokerages commission charge and an exchange's ask/bid
charge, and it can be even higher if you place a stop-loss order. (Therefore, spread betting is more suited to longterm trading and not short-term day trading - high commissions will take away any profits.)
But the value of a spread betting contract can be around half that of a real futures contract.

Therefore, the amount of money you need to put into an account, to bet on a commodity, or the amount you can lose,
is about half that of trading a real contract. You can often put a guaranteed stop loss order on your bet, too, which
avoids the pitfalls of 'gapping' prices. (For example, say you were long on Gold and your stop-loss was at 290. The
market opened well down at 285, you would be stopped at 290 with your guaranteed stop. Trading a normal futures
contract, your broker would have to stop you out at 285 and you would lose an extra $500.)
Also, any profits you make from a spread-bet will be free from capital gains tax.

Options Trading
Options trading is available on a number of investments including futures contracts. Options trading is a complete
subject in itself and can be more complicated that futures trading to understand. But basically, using an option gives a
trader the right to buy or sell a contract at a future date, but not the obligation.
The trader needs to pay a premium for this choice which can often work out less expensive than the margin
requirements - or the risk to a stop-loss order - in trading the futures contract. Should the trader not exercise the
option, he would lose the premium he paid for the option. But should he exercise it, he could make a lot of money.
There is a lot of terminology in options trading and it can be more complex than the simple 'buy or sell' method of
futures trading.

Managed Futures Trading

It has been reported that up to 95% of investors speculating on futures markets end up losing money (source: Bridge
Trader magazine). The reasons for this could be that many naiive investors become enticed by the potential huge
rewards associated with futures, when they are ill-prepared to compete with the thousands of professional traders,
some with decades of experience, access to the trading pits, the use of million dollar technology, etc.
The markets can be cruel, and you should be prepared for the worst.
An alternative is to use the skills of professional traders who can manage your account to trade the exciting futures
markets. This is known as Managed Futures Trading. A Commodity Trading Advisor (CTA) can be used to trade a
client's funds under Power of Attorney. Computerized trading systems can also be used in order to stick rigidly to a
trading system
Futures Trading Tips
Below are the 24 Trading Tips based on the methods of W.D. Gann. By following these money management rules,
your trading account should remain in tact even after a string of losing trades.

1. Gann recommended dividing one's trading capital into 10 equal parts and never using more than 1 part to trade any
commodity. In effect, this risks 10% of trading capital on any position. However, many other top traders such as those
featured in the Market Wizards books recommend using only 1 or 2% per trade.
2. Spread your risk over a range of different markets, for example, stock index, currency, and several commodities like
grain, livestock, energy, metals, industrials, softs.
3. Always use Stop Loss Orders to protect capital whenever you make a trade, and move them to protect profits.
4. Never over-trade. Trading up to 5 or 6 markets at a time has been recommended by some traders such as WD
Gann and Larry Williams.
5. Never let a profit run into a loss. As soon as a trade becomes profitable, move your stop loss to lock in profits.
6. Always trade with the trend, never against it.

7. "When in doubt, get out." If you are unsure of the market position it is safest to exit with a guaranteed profit or small
loss. If you can, try and buy on dips or down-days and sell on peaks or up-days.
8. Avoid congesting markets and only trade in markets that are trending.
9. Trade in a variety of different markets to spread risk.
10. Never close a trade without good reason and follow up with a stop loss order to protect profits.
11. Create a surplus account. When you have made some profits place them aside to use only in an emergency.
12. Never average a loss. Practise on paper until you make regular profits Do this in real-time NOT on historic data
because it is too easy to optimise a trading system to fit past results.
13. Never enter a market just because you have become bored of waiting, or exit a trade because you have lost
patience.
14. Avoid taking small profits and big losses.
15. Never cancel a stop-loss order once you have placed it.
16. Avoid entering and exiting the market too often. Although there are reports of Gann making hundreds of trades in a
small period of time, these were typically for exhibition purposes. In reality, Gann would only make a handful of
commodity trades a year.
17. Be as prepared to sell short as to buy long and always follow the trend.
18. Never buy just because the price of a commodity is low or sell because it is high. For example, just because Crude
Oil fell from $40 to $20 would not be a good buy trade if Crude then fell to $10! (Which it did a few years ago.)
19. Avoid hedging, e.g. buying wheat and covering the position by selling corn; Or buying one Wheat contract month
and selling a different Wheat contract month.
20. Be careful with pyramiding and plunging (adding to positions). For example, if you have bought Oats and the
market keeps falling avoid buying more contracts on the premise that the market ''has to turn soon'' (plunging).
Instead, try and exit for a small loss as soon as the trade has made a small loss.
Similarly, be careful "putting all your eggs in one basket" adding to positions if your analysis has proved correct
(pyramiding). Only consider pyramiding if Rule 1 allows you sufficient funds to do so.
21. Never change your position in the market without good reason.
22. Avoid increasing your trading after a long period of success or failure. It is easy to think of yourself as "invincible"
after winning a succession of trades. This is the reason most gamblers lose money.
23. Never guess when the market is at top or bottom. Always wait for a definite signal first.
24. Never increase trading to win back profits.

Options Basics: What Are Options?

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a
specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract
with strictly defined terms and properties.
Still confused? The idea behind an option is present in many everyday situations. Say, for example, that you discover
a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You

talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of
$200,000. The owner agrees, but for this option, you pay a price of $3,000.
Now, consider two theoretical situations that might arise:
1. It's discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house
skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for
$200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).
2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost
of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in
the basement. Though you originally thought you had found the house of your dreams, you now consider it
worthless. On the upside, because you bought an option, you are under no obligation to go through with the
sale. Of course, you still lose the $3,000 price of the option.
This example demonstrates two very important points. First, when you buy an option, you have a right but not an
obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless.
If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an
option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which
means an option derives its value from something else. In our example, the house is the underlying asset. Most of the
time, the underlying asset is a stock or an index.
Calls and Puts
The two types of options are calls and puts:
1. A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are
similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially
before the option expires.
2. A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very
similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the
option expires.
Participants in the Options Market
There are four types of participants in options markets depending on the position they take:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said
to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers:

Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their
rights if they choose.

Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be
required to make good on a promise to buy or sell.

Don't worry if this seems confusing - it is. For this reason we are going to look at options from the point of view of the
buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there
are two sides of an options contract.
The Lingo
To trade options, you'll have to know the terminology associated with the options market.
The price at which an underlying stock can be purchased or sold is called thestrike price. This is the price a stock price
must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur
before the expiration date.
An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is
known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100
shares of company stock (known as a contract).
For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-themoney when the share price is below the strike price. The amount by which an option is in-the-money is referred to
as intrinsic value.
The total cost (the price) of an option is called the premium. This price is determined by factors including the stock
price, strike price, time remaining until expiration (time value) and volatility. Because of all these factors, determining
the premium of an option is complicated and beyond the scope of this tutorial.
Options Basics: Why Use Options?
There are two main reasons why an investor would use options: to speculate and to hedge.
Speculation
You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't
limited to making a profit only when the market goes up. Because of the versatility of options, you can also make
money when the market goes down or even sideways.
Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason
options have the reputation of being risky. This is because when you buy an option, you have to be correct in
determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement.
To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much
the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The
combinations of these factors means the odds are stacked against you.

So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about
using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to
generate substantial profits.
Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car,
options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of
your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that
hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that
you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By
using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way. (For
more on this, see Married Puts: A Protective Relationship and A Beginner's Guide To Hedging.)
A Word on Stock Options
Although employee stock options aren't available to everyone, this type of option could, in a way, be classified as a
third reason for using options. Many companies use stock options as a way to attract and to keep talented employees,
especially management. They are similar to regular stock options in that the holder has the right but not the obligation
to purchase company stock. The contract, however, is between the holder and the company, whereas a normal option
is a contract between two parties that are completely unrelated to the company
Options Basics: How Options Work
Now that you know the basics of options, here is an example of how they work. We'll use a fictional firm called Cory's
Tequila Company.
Let's say that on May 1, the stock price of Cory's Tequila Co. is $67 and the premium (cost) is $3.15 for a July 70 Call,
which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is
$3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this
example.
Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to
get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is
worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15.
When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've
paid $315 for the option, so you are currently down by this amount.
Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now
worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You
almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and
take your profits - unless, of course, you think the stock price will continue to rise. For the sake of this example, let's
say we let it ride.
By the expiration date, the price drops to $62. Because this is less than our $70 strike price and there is no time left,

the option contract is worthless. We are now down to the original investment of $315.
To recap, here is what happened to our option investment:
Date

May 1

May 21

Expiry Date

Stock Price

$67

$78

$62

Option Price

$3.15

$8.25

worthless

Contract Value

$315

$825

$0

Paper Gain/Loss

$0

$510

-$315

The price swing for the length of this contract from high to low was $825, which would have given us over double our
original investment. This is leverage in action.
Exercising Versus Trading-Out
So far we've talked about options as the right to buy or sell (exercise) the underlying. This is true, but in reality, a
majority of options are not actually exercised.
In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a
profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value.
However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This
means that holders sell their options in the market, and writers buy their positions back to close. According to the
CBOE, about 10% of options are exercised, 60% are traded out, and 30% expire worthless.

Intrinsic Value and Time Value

At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option
went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value.
Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-themoney, which, for a call option, means that the price of the stock equals the strike price. Time value represents
thepossibility of the option increasing in value. So, the price of the option in our example can be thought of as the
following:
Premium = Intrinsic Value
$8.25 = $8

Time Value

$0.25

In real life options almost always trade above intrinsic value. If you are wondering, we just picked the numbers for this
example out of the air to demonstrate how options work.

Options Basics: Types Of Options

There are two main types of options:

American options can be exercised at any time between the date of purchase and the expiration date. The
example about Cory's Tequila Co. is an example of the use of an American option. Most exchange-traded
options are of this type.

European options are different from American options in that they can only be exercised at the end of their
lives.

The distinction between American and European options has nothing to do with geographic location.
Long-Term Options
So far we've only discussed options in a short-term context. There are also options with holding times of one, two or
multiple years, which may be more appealing for long-term investors.
These options are called long-term equity anticipation securities(LEAPS). By providing opportunities to control and
manage risk or even to speculate, LEAPS are virtually identical to regular options. LEAPS, however, provide these
opportunities for much longer periods of time. Although they are not available on all stocks, LEAPS are available on
most widely held issues.
Exotic Options
The simple calls and puts we've discussed are sometimes referred to as plain vanilla options. Even though the subject
of options can be difficult to understand at first, these plain vanilla options are as easy as it gets!
Because of the versatility of options, there are many types and variations of options. Non-standard options are
called exotic options, which are either variations on the payoff profiles of the plain vanilla options or are wholly different
products with "option-ality" embedded in them.

Implied Volatility (IV) Bid/Ask (%): This value is calculated by an option pricing model such as the Black-Scholes
model, and represents the level of expected future volatility based on the current price of the option and other known
option pricing variables (including the amount of time until expiration, the difference between the strike price and the
actual stock price and a risk-free interest rate). The higher the IV Bid/Ask (%)the more time premium is built into the
price of the option and vice versa. If you have access to the historical range of IV values for the security in question
you can determine if the current level of extrinsic value is presently on the high end (good for writing options) or low
end (good for buying options).
Delta Bid/Ask (%): Delta is a Greek value derived from an option pricing model and which represents the "stock
equivalent position" for an option. The delta for a call option can range from 0 to 100 (and for a put option from 0 to
-100). The present reward/risk characteristics associated with holding a call option with a delta of 50 is essentially the
same as holding 50 shares of stock. If the stock goes up one full point, the option will gain roughly one half a point.
The further an option is in-the-money, the more the position acts like a stock position. In other words, as delta
approaches 100 the option trades more and more like the underlying stock i.e., an option with a delta of 100 would

gain or lose one full point for each one dollar gain or loss in the underlying stock price. (For more check out Using the
Greeks to Understand Options.)
Gamma Bid/Ask (%): Gamma is another Greek value derived from an option pricing model. Gamma tells you how
many deltas the option will gain or lose if the underlying stock rises by one full point. So for example, if we bought the
March 2010 125 call at $3.50, we would have a delta of 58.20. In other words, if IBM stock rises by a dollar this option
should gain roughly $0.5820 in value. In addition, if the stock rises in price today by one full point this option will gain
5.65 deltas (the current gamma value) and would then have a delta of 63.85. From there another one point gain in the
price of the stock would result in a price gain for the option of roughly $0.6385.
Vega Bid/Ask (pts/% IV): Vega is a Greek value that indicates the amount by which the price of the option would be
expected to rise or fall based solely on a one point increase in implied volatility. So looking once again at the March
2010 125 call, if implied volatility rose one point from 19.04% to 20.04%, the price of this option would gain $0.141.
This indicates why it is preferable to buy options when implied volatility is low (you pay relatively less time premium
and a subsequent rise in IV will inflate the price of the option) and to write options when implied volatility is high (as
more premium is available and a subsequent decline in IV will deflate the price of the option).
Theta Bid/Ask (pts/day): As was noted in the extrinsic value column, all options lose all time premium by expiration.
In addition, "time decay" as it is known, accelerates as expiration draws closer. Theta is the Greek value that indicates
how much value an option will lose with the passage of one day's time. At present, the March 2010 125 Call will lose
$0.0431 of value due solely to the passage of one day's time, even if the option and all other Greek values are
otherwise unchanged.
Volume: This simply tells you how many contracts of a particular option were traded during the latest session.
Typically though not always - options with large volume will have relatively tighter bid/ask spreads as the competition
to buy and sell these options is great.
Open Interest: This value indicates the total number of contracts of a particular option that have been opened but
have not yet been offset.
Strike: The "strike price" for the option in question. This is the price that the buyer of that option can purchase the
underlying security at if he chooses to exercise his option. It is also the price at which the writer of the option must sell
the underlying security if the option is exercised against him.
A table for the respective put options would similar, with two primary differences:
1. Call options are more expensive the lower the strike price, put options are more expensive the higher the
strike price. With calls, the lower strike prices have the highest option prices, with option prices declining at
each higher strike level. This is because each successive strike price is either less in-the-money or more outof-the-money, thus each contains less "intrinsic value" than the option at the next lower strike price.
With puts, it is just the opposite. As the strike prices go higher, put options become either less-out-of-themoney or more in-the-money and thus accrete more intrinsic value. Thus with puts the option prices are
greater as the strike prices rise.

2. For call options, the delta values are positive and are higher at lower strike price. For put options, the delta
values are negative and are higher at higher strike price. The negative values for put options derive from the
fact that they represent a stock equivalent position. Buying a put option is similar to entering a short position in
a stock, hence the negative delta value.
Option trading and the sophistication level of the average option trader have come a long way since option trading
began decades ago. Today's option quote screen reflects these advances.

Options Basics: Conclusion

By Investopedia Staff
We hope this tutorial has given you some insight into the world of options. Once again, we must emphasize that
options aren't for all investors. Options are sophisticated trading tools that can be dangerous if you don't educate
yourself before using them. Please use this tutorial as it was intended - as a starting point to learning more about
options.
Let's recap:

An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a
specific price on or before a certain date.

Options are derivatives because they derive their value from an underlying asset.

A call gives the holder the right to buy an asset at a certain price within a specific period of time.

A put gives the holder the right to sell an asset at a certain price within a specific period of time.

There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of puts, and
sellers of puts.

Buyers are often referred to as holders and sellers are also referred to aswriters.

The price at which an underlying stock can be purchased or sold is called the strike price.

The total cost of an option is called the premium, which is determined by factors including the stock price,
strike price and time remaining untilexpiration.

A stock option contract represents 100 shares of the underlying stock.

Investors use options both to speculate and hedge risk.

Employee stock options are different from listed options because they are a contract between the company
and the holder. (Employee stock options do not involve any third parties.)

The two main classifications of options are American and European.

Long term options are known as LEAPS.

Going Long On Calls

As your knowledge of puts and calls grows, you will want to consider trading strategies that can be used to make
money in the options market. One of these is buying call options and then selling or exercising them to earn a profit.
Covering a call is the act of selling calls to someone in the market in exchange for the option premium. When you're
buying a call, you will be paying the option premium in exchange for the right (but not the obligation) to buy shares at a
fixed price by a certain expiry date. (If you need to brush up on the basics of option trading, please see the Options
Basics Tutorial.)
Trading Calls: Is It My Calling?
The popular misconception that over 90% of all options expire worthless frightens a lot of investors. They believe this
incorrect statistic and then conclude that, if they buy options, they will lose money 90% of the time! This is completely
false. In fact, according to the CBOE, about 30% of options expire worthless, while 10% are exercised and the other
60% are traded out or closed by creating an offsetting position.
The focus of this article is the technique of buying calls and then selling them or exercising them for a profit. We will
not consider selling calls and then buying them back at a cheaper price - this is called naked call writing and is a more
advanced topic. (To learn more, read Naked Call Writing or To Limit Or Go Naked, That Is The Question.).
In this article the term "trading calls" means first buying a call and then closing out the position later - such a strategy
is called "going long" on a call. (To learn more about making money going long on a put, see Prices Plunging? Buy A
Put!)

The Underlying Idea

The basic reason for buying calls is that you are bullish on a stock. Why couldn't you just buy the stock and not worry
about options? After all, stocks never expire - you could hold onto a stock forever - whereas options do. So, why
consider an investment that has an expiry date? The reason is simple: leverage.
Consider the following example: XYZ stock trades for $50. The XYZ $50 call that expires in a month trades for $3.
Would you like to buy 100 shares of XYZ for $5,000 or buy one call option for $300 ($3 x 100 shares)? One important
thing to consider is that payoffs depend on closing prices a month from today. (The example deals with a one-month
option, but you can have options that last for different lengths of time. LEAPS, for instance, expire more than a year
away.) Let's look at a graphic illustration of your choice:

As you can see from the graph, the payoffs for each investment are different. While buying the stock would require an
investment of $5,000, you could, with an option, control an equal number of shares for only $300. You'll also note that
the break-even point on the stock trade is $50 per share, while the break-even on the option trade is $53 per share
(ignoring all commissions).
The key point, however, is that while both investments have unlimited upside within the next month, the losses on the
options are capped at $300, while the potential losses on the stock could go all the way to $5,000. Remember that
buying a call option gives you the right but not the obligation to buy the stock, so your maximum losses are the
premiums you paid.
Closing Out The Position
You can close out your call position by selling the call back into the market or by having the calls exercised, in which
case you would have to deliver cash to the person who sold you the call. Say that in our example, the stock was at
$55 near expiry. You could sell your call for approximately $500 ($5 x 100 shares), which would give you a net profit of
$200 ($500 minus the $300 premium). Alternatively, you could have the calls exercised, in which case you would have
to pay $5,000 ($50 x 100 shares), and the person who sold you the call would deliver the shares. With this approach,
your profit would also be $200 ($5,500 - $5,000 - $300 = $200). Note that the payoff from exercising or selling the call
is identical: a net of $200.
Conclusion
Trading calls can be a great way to increase your exposure to a certain stock without tying up a lot of funds. Because
options allow you to control a large amount of shares with relatively little capital, they are used extensively by mutual
funds and large investors. As you can see, trading calls can be used effectively to enhance the returns of a stock
portfolio.

Call Option vs. Put Option

Options give investors the right but no obligation to trade securities, likestocks or bonds, at predetermined
prices, within a certain period of time specified by the option expiry date. A call option gives its buyer the option
to buy an agreed quantity of a commodity or financial instrument, called the underlying asset, from the seller of
the option by a certain date (the expiry), for a certain price (the strike price). A put option gives its buyer the right
to sell the underlying asset at an agreed-upon strike price before the expiry date.
The party that sells the option is called the writer of the option. The option holder pays the option writer a fee
called the option price or premium. In exchange for this fee, the option writer is obligated to fulfill the terms of the
contract, should the option holder choose to exercise the option. For a call option, that means the option writer is
obligated to sell the underlying asset at the exercise price if the option holder chooses to exercise the option. And
for a put option, the option writer is obligated to buy the underlying asset from the option holder if the option is
exercised.
Comparison chart
Differences Similarities

Definition

Costs

Obligations

Value

Analogies

Call Option

Put Option

Buyer has the right, but is not required,

to buy an agreed quantity by a certain
date for a certain price (the strike price).

Buyer has the right, but is not required,

to sell an agreed quantity by a certain
date for the strike price.

Premium paid by buyer

Premium paid by buyer

Seller (writer of the call option) obligated

to sell the underlying asset to the option
holder if the option is exercised.

Seller (writer of a put option) obligated

to buy the underlying asset from the
option holder if the option is exercised.

Increases as value of the asset

increases

Decreases as value of the underlying

asset increases

Security deposit allowed to take

something at a certain price if the
investor chooses.

Insurance protected against a loss in

value.

Why Buying in-the-Money Call Options Is a Smart Move

Although options should be part of any balanced portfolio, when it comes to buying stocks that you don't plan to keep
in your account for the long haul, nothing beats using call options as a short-term surrogate. Not only can you close
the position at any time (or simply wait until expiration, when it gets closed for you), but you can bank similar returns
for a fraction of the cash outlay.

In fact, you can be making even more money on the capital you'd originally planned to allocate to stock buying. So,
when someone tells you that you have to spend money to make money, you can show them the fat returns you're
making by saving money instead of spending it all in one place!
In fact, you can greatly reduce your risk if you take your 500 shares of ABC stock, sell it, and then buy five ABC call
options that are in the money by a few strike prices.
(I'll explain which expiration date the call options should have in a minuteand yes, that's important.)
If ABC is trading at $60 per share and you pull up the option chain and look at the 2009 January calls, you might see
the following call options available:
* ABC Jan 60 calls trading at $9 (These are at the money)
* ABC Jan 55 calls trading at $12 (These are in the money by one strike price.)
* ABC Jan 50 calls trading at $15 (These are in the money by two strike prices.)
* ABC Jan 45 calls trading at $18.50 (These are in the money by three strike prices.)
Make Money By Spending Less
It makes more senseinstead of buying 500 shares of ABC stock at $60 (for $30,000)to buy five of the ABC Jan 45
calls at $18.50 (for $9,250). Then, put the remaining $20,750 in a money market account and earn a 5% return on that
"extra" cash.
In this case, the intrinsic value of the Jan 45 call is $15 (because the stock price of $60 minus the strike price of $45 =
$15) and the extrinsic value of the call option is the remaining $3.50 (because the call costs $18.50 minus $15 intrinsic
value = $3.50).
This means that during the life of the call option (especially in the last few months leading up to the January
expiration), that $3.50 extrinsic value (i.e., "time value") deteriorates. So, if your ABC stock trades flat at $60 for the
next few months, the option would lose $3.50 and be worth $15.
Keep in mind that the $3.50 loss (assuming that you actually held on for the next few months) is a loss of $1,750. But,
since you put the rest into a risk-free money market account, you would have earned $1,383.33 in interest.
So, the loss is reduced to $366.67. (And that would equate to 73 cents of the call option instead of $3.50 per share.)
So, what are you getting in return for your willingness to lose 73 cents during the course of a few months on a $60
stock that really only equates to 1.21%?
Number One: Broader Market Downtrends are Less Nervewracking
You know that your absolute maximum downside risk is the $18.50 (or $9,250) that you invested in the call option,
instead of the $60 (or $30,000) on the stock that likely wouldn't lose all of its value. But, as we know, a loss of anything
between one cent and $30,000 is possible.
There are many benefits here that one wouldn't consider at first. One of them is the psychological gain. I mean, you
would be a lot less worried about the stock market crashing, and this would allow you to feel more confident about
buying when people are fearful. That means that you would be buying when things are down.

Also remember that you should usually play both sides of the market. So, you can also buy in-the-money put options
to bet on the downside. That means if the stock is at $60, and you were betting that it would trade lower, you would
buy the in-the-money Jan 75 puts.
Number Two: Similar Gains to Buying the Stock
If your stock moves higher, you are making almost the same amount that you would have made on the stock.

Number Three: Smaller Losses

If your stock moves lower, you are probably going to lose much less than you would have on the stock. A very basic
hypothetical example is that if the stock trades up ten points, you will probably make nine to 9.5 points, but if the stock
trades down ten points, you will probably lose about seven points.
So you see, the downside-versus-upside ratio is less than par. You only get the downside-versus-upside ratio benefit if
you do two important things:
1) Buy the options that are in the money by a few strike prices, and
2) Buy an option that has a long while to go until expiration day. This "long while" should probably be one year or
more.
So, in the example used above, January can be the furthest-out available LEAP. The ultimate goal is to be out of the
position at least three months before the option expires.