Section 7: Tips for buying and selling options on futures
One of the most valuable lessons a novice trader can learn is how to execute an option trade. If you try and place a market order in a futures option pit you will probably fall out of your chair when you see where they fill you. Even a liquid market like the US Treasury Bonds have very large swings between the highs and lows of the day for any given option strike. Much of this swing is based on the fact that there are so many strikes of puts and calls so the 'market' on any given strike may not be that liquid. If you place an order to sell an option at the market you're basically giving free money to the executing broker.
The best way to avoid this is to always use limit orders to enter and exit your trade. When opening an option trade its important to remember that you're better off not taking a trade if you can't get your price. When you just have to buy something you can try a market on close order but even these are not recommended unless you have experience with the option and have a good idea of where you'll be filled.
In order to assess what price might be fair for a given strike I look at the settlement prices for the previous day and base my decision on these. Everyone wants the options to settle at fair prices so their books balance. Mispriced options can throw off spreads and potentially cause unwarranted margin calls for large traders with large positions. This is something that most everyone wants to avoid so the settlement prices for options are usually quite fair.
By using the closing prices for an option chain you can get a good feel for what should happen if the market starts moving. Here are the current option prices for the US Treasury Bond Calls for March 2008 when the market setteled at 117'24. Please note that bond options are traded in 1/64 ticks of $1,000 points so each tick is worth $15.63.
Strike Price
118 1'61
119 1'34
120 1'11
121 57
122 43
123 32
In order to assess what the 120 option might be worth based on a one point price move in the bonds, all you need to do is look at the 119 and 121. If we woke up tomorrow and the market was up 1 point we'd expect the 120 to move to 1'34 while a one point move against would move it to 57. If you have a ˝ point move you split the difference. So, if the market is up 16 ticks in the bonds and I wanted to buy a 120 I would place a limit order to buy one call at about 1'20, the difference between the two prices plus a small premium in case someone else does a market order. Conversely, If I wanted to sell I would place the order around 1'26.
The hardest thing to do is cancel replace an order to chase a lower price. If you are trying to buy the 121 calls at 50 and the market drops a point in a short move you will probably not be able to replace your price. As soon as you do they will likely fill it at the price you asked even though the fair value is considerably lower. With this in mind it is almost always better to let an option come to you rather than trying to rush in.
Options have several things working against the holder and bad fills are often one of the hardest things to overcome. If you take a protective stand your money you’ll find yourself in a better position to survive. Buying options is a risky venture as 90% expire with no value. You need to do everything in your power to protect your money in this volatile asset class.
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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