Section 1: Understanding the basics of futures options trading
The easiest way to explain how options work is to lay out an example. The S&P 500 is currently one of the most liquid futures contracts traded so we'll continue to use the January 1st example where the market is trading at 1,400. An option trader would have to purchase several different kinds of options based on his opinion of the market and tolerance for risk.
If you are:
Bullish with a High Risk Tolerance, then you could Sell Puts
Bullish with a Low Risk Tolerance, then you could Buy Calls
Bearish with a High Risk Tolerance, then you could Sell Calls
Bearish with a Low Risk Tolerance, then you could Buy Puts
Due to the fact that most options expire with no value, it is possible to write them and have a higher probability of a profit but the risk will be much greater and you can only make a profit equal to what you received for the option when you sold it. This is one of the hardest choices an option trader will have to make. Do you try and make the easy premium or try and catch a large move and a greater return.
You should always be aware that the writer of an option has the odds in his favor but the potential loss is substantial. Its almost like writing insurance against an adverse price move in the market. If a pension fund wants to protect itself against a giant decline in the S&P 500 they would consider purchasing puts at 1,300 so their loss would always be limited to 8% on the down side. They would pay something like 20 points (or 1%) of the portfolio value to ensure that they never had a loss of their principal beyond their obligations. This is very much like buying insurance that you hope you never have to use. The pension fund is the buyer of the insurance and the option writer (seller) is the insurance agency. We all know that insurance companies are one of the most profitable businesses you can run but the risks are huge. Warren Buffet made much of his money from taking on the risk that other people are not in a position to accept. Writers of options make money in the same fashion as they expose themselves to market crashes, panics and manias but they thrive in a business as usual environment with stable commodity prices.
An option has a price that's based on several components which are all readily available from the internet or the newspaper.
In order to understand the risk and reward characteristics between puts and calls let's take a look at the profit and loss potential for a hypothetical market. The current market is trading at $5 and the puts and calls with a strike price of $5 are both priced at $1. The following four tables will show you the profit and loss potential based on where the market is trading on the day of expiration.
Futures-option-trading.com
1: Futures option trading basics
2: How to price futures options
3: Understanding the Greeks
4: Using option spreads
5: Synthetic options and futures
6: Strategies
7: Tips for buying and selling
8: Risk Disclosures for options
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