PROFITING WITH

FUTURES OPTIONS

David L. Caplan

Disclaimer: Trading in futures and options is

not suitable for all investors as the risk of loss
is substantial. Purchasers of options may lose
their entire investment. Sellers of Options are
subject to unlimited risk.

Center for Futures Education, Inc.

P.O. Box 309
Grove City, PA 16127
(724) 458-5860
FAX: (724) 458-5962
e-mail: info@thectr.com
http://www.thectr.com

1
 TABLE OF CONTENTS

INTRODUCTION 5
I. THE BASICS OF OPTION TRADING 9
Option Strike Price 9
Expiration 11
Volatility 11
II. WHEN TO USE OPTIONS 15
The Trading Edge 15
When to Buy Options 16
When to Sell Options 17
When to Use Options with Futures 18
III. OPTION SPREAD STRATEGIES 19
Option Strategies that Provide the Trader with a
Significant Advantage 20
IV. USING NEUTRAL OPTION POSITIONS 22
V. THE “FREE TRADE” 25
VI. THE “RATIO SPREAD” 27
VII. THE MOST OVERLOOKED OPTION
BUYING STRATEGIES (DON’T TRADE
ANOTHER FUTURES CONTRACT UNTIL
YOU READ THIS!) 30
The In-the-Money Debit Spread 30
Option Straddle Purchase 31
VIII. THE MOST OVERLOOKED OPTION SELLING
STRATEGIES 34
Covered Call—Additional Income; No Risk or Margin 34
Calendar Option Strategy—Take Advantage of
Disparities in Futures and Options 35
CONCLUSION 37
APPENDICES
1. Common Option Strategies for All Markets 38
2. Neutral Option Spread Strategies 41
3. Option Strategy Summary 43
4. Glossary of Option Terms 44

3
 INTRODUCTION
Options provide one of the most overlooked opportunities avail-
able to traders today. Properly used, options provide significant ad-
vantages for all traders; however, most traders tend to misuse them.

Often traders who use options purchase

or sell the wrong option, or use the
wrong option strategy.

New traders often use options solely to limit risk, in which case
they only buy them. They do little investigation to determine whether
the option was relatively “undervalued” or “overvalued,” or which
strike price or month was the best. Typically, the conversation be-
tween a trader and his broker goes something like this:

TRADER: “I think gold is going up.”

BROKER: “O.K. What would you like to do?”
TRADER: “I want to buy gold, but I only have $1,000 to risk.”
BROKER: “Let’s see, with $1,000, we can buy 4 June $400 calls.”
TRADER: “Great! Go ahead.”

There is no consideration given to time decay or premium levels—

the most important factors in option trading—or whether an option
strategy would provide a better risk/reward ratio than a futures posi-
tion.
Traders who limit their analysis of options to buying a call option if
they are bullish on a market or buying a put if they are bearish with the
expectation that they will profit if the market moves in the predicted
direction not only fail to take advantage of the most important aspect
of options (under/over pricing, premium disparity, and time decay),
but also find that indiscriminate option purchases can lead to losses

5
even if the market moves in your favor!
There are three objectives that we have when trading options:
“NEUTRAL” POSITIONS THAT HAVE HIGH PROBABILITY OF
PROFIT, OR SITUATIONS THAT HAVE IN THE PAST ALWAYS LED
TO EXPLOSIVE MARKET MOVES, PROVIDING US WITH RISK/
REWARDS OF 20-1 OR MORE!

1. “NEUTRAL OPTION POSITIONS” WITH A HIGH PROBABILITY

OF PROFIT. THESE TRADES MEET THE FOLLOWING
CRITERIA:
A. They can be profitable over a wide range of prices that can be
calculated by statistical probability to be profitable a high percentage
of the time;
B. They can be successful without having to predict exact market
direction;
C. They benefit from mispriced options (premium disparity) and from
selling “overvalued” options;
D. They take advantage of “time decay” of out-of-the-money options
that will lose some of their time value every day.
Bond Neutral Options

FUTURES CHARTS
COURTESY FUTURESOURCE
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Figure 1

6
2. USING OPTION PURCHASES IN CONSOLIDATING MARKETS
IN COMBINATION WITH LOW OPTION VOLATILITY LEVELS
TO PRODUCE TRADES THAT CAN HAVE A 20-1 OR MORE
PROFIT TO RISK RATIO!

Option purchasing is one of the most misused of all trading techniques.

Most traders prefer to purchase options because of their limited risk (with
premium plus commissions and fees), and their unlimited profit aspect, which
provides the trader, in effect, a “lottery ticket” with the potential of large
gains. However, similar to a lottery ticket, well over 90% of traders who
purchase options in this manner end up losing! (In fact, our “Neutral Strat-
egies” are designed to take advantage of people who purchase options in
this indiscriminate manner.)
However, there is one situation where the odds in option buying are
favorable and can produce some of our biggest gains. It is one of the
easiest patterns of all to recognize and trade.
This occurs when a market consolidates into a quiet trading range.
Traders say that the market has reached its “equilibrium” level and that it
will have very little movement.
Futures contracts open near unchanged levels, and move only a few
ticks in either direction every day. Traders are lulled “asleep” by this action.
Option volatility then moves to record low levels making options very cheap.
WHAT HAS HAPPENED IN THESE SITUATIONS ? THE
MARKET HAS QUICKLY BROKEN OUT AND MOVED SHARPLY
HIGHER.
The soybean market in 1988; the coffee market in 1997, are examples
of markets that were trading just a few ticks a day for long periods of time
with extremely low option volatility that eventually broke out and moved
much higher.
As an additional benefit, these situations are the easiest to recognize
and trade of any possible technical pattern. That’s because they all look
and act the same. As you can see in Figure 1, they are all easily recognized
by the long, consolidating, quiet action. We then wait for the market to “tell
us” that it is ready to begin moving before initiating any trades.

3. USING OPTION STRATEGIES AND PREMIUM DISPARITY TO

INITIATE POSITIONS THAT PROVIDE SIGNIFICANT BENEFITS
(DESCRIBED IN CHAPTERS III TO VIII).

7
 FUTURES CHARTS
COURTESY FUTURESOURCE
(800) 621-2628

Monthly Gold

Monthly Soybeans Monthly Copper

8
 Figure 2

CHAPTER I
THE BASICS OF OPTION TRADING

There are two types of options: calls and puts. A call option gives the
option buyer the right to buy the underlying asset at a specified price (the
strike price) within a certain time. It obligates the option seller to sell that
asset at the strike price before the expiration date, should the call buyer
exercise his right. Conversely, a put option gives the option buyer the right
to sell the underlying futures at a specified price within a certain time, and
obligates the seller to take delivery at the strike price on or before the
expiration date if the put buyer exercises his right. (Although the examples
in this book refer to futures options, the principles apply to other option
markets also).
All option transactions are opened either by buying or selling a call or
put.

Over 90% of options transactions are

closed out with an offsetting sale or
purchase of the same option, or by
letting the option expire without
exercising the right to take or
tender delivery.

Options can be bought or sold to take advantage of a market move; for

example, if an investor thinks the price of gold is going to rise, he can pur-
chase a call or sell a put on the futures. If he purchases a call and the price
of gold rises, the investor will profit if the premium he paid for the call
increases during the time he holds the option.
If he sells a put instead and the price of gold rises above the strike price
at expiration, the premium he received for selling the put will be his profit.
If the investor anticipates the price of gold falling, he can buy a put or sell a
call option.

Option Strike Price

The price (premium) that the option buyer must pay for an option is
9
determined by several factors. One is the strike price of the option; for
example, if gold is trading at $320 an ounce, an investor who is bullish on
gold could buy a call option at a strike price of $310, $320, or $330 an ounce.
A $310 call option is “in-the-money,” that is, the strike price is lower than
the market price. This is the most expensive of the options in this example.
The $320 strike price is “at-the-money” (close to the market), the second
most expensive option. The $330 option is the “out-of-the-money” and is
the least expensive of these options. The farther “out-of-the-money” an
option is, the less expensive it is, because it is less likely to have any real
(intrinsic) value before expiration.
In our example, let’s say the December $310 call costs $1500; the $320
call costs $1000; and the $330 call costs $700. If, at the expiration of the
December gold option, gold is trading at $330 an ounce, the $310 option
would be worth $2,000* (gold options are for 100 oz. contracts) and thereby
have a profit of $500* ($2,000 value minus $1,500 we paid for the option);
the $320 option would be worth $1000 and our investor would break even;
and the $330 call option buyer would lose his entire $700* investment.
Although the price of gold has risen $10 dollars, his option still lost money,
because the price of gold did not exceed the price he paid for the call.
On the other hand, the seller of the $330 call was wrong in his price
prediction for gold, but he still profited on this sale; thus, you can be right in
your prediction of market direction and still lose money! How is this pos-
sible? There are two reasons for this.

1. An option is a “wasting asset.” The option premium is partially comprised

of time value; the longer the option has until expiration, the more value
it should have. With every passing day, the option will lose some of its
time value. Even if the buyer of the call option is correct in his assessment
of the direction of the market—the market is rising—the time value of
the option will decrease.

Only when a sustained or

swift, sharp upward move
occurs will the call purchaser make money.

* Less commissions and fees.

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 x
FUTURES CHARTS
COURTESY FUTURESOURCE
(800) 621-2628

Relative Option Value

E
3 2 Months 1

Figure 3
Option time premium declines slowly when there is a long time remaining until expiration.
As expiration approaches, the disintegration accelerates.

2. Options are often overpriced because the public is willing to pay

professional writers and grantors of options large premiums so the public
can speculate in the markets, attempting to make a large profit with a
limited risk of loss (option premium plus commissions and fees). If options
were not overpriced, grantors would be unwilling to sell them and take
the risk of a theoretically unlimited loss.

Expiration

A second important aspect in the determination of option premium is

the time until expiration; for example, an October gold call will cost less to
purchase than a December gold call of the same strike price. The reason:
the additional time before expiration gives the December option buyer a
greater opportunity for profit.

Volatility

The third item of importance is the volatility of the underlying futures

contract. Volatility is a measure of historical price changes. A commodity
such as soybeans or silver, which at times can be subject to violent price
moves, normally commands very high premium values, especially during
periods of violent price moves; e.g., soybeans during the summer months.
11
 Volatility is by far the most important aspect in option trading, yet it is
the least understood and most misused.
Volatility is a mathematical computation of the magnitude of movement
in an option. This is based on the activity in the underlying market. If the
market is making a rapid move up or down, volatility will increase. In a quiet
market, volatility will be low.

Monthly Corn Chart

FUTURES CHARTS
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Figure 4

When volatility is relatively low, a trader should look for option buying
strategies, as the market is quite likely to make a strong move. When option
volatility is high, option selling strategies should be considered to take
advantage of the relatively overvalued premiums.
An overlooked area is the difference in volatility between different
months and strike prices of options. Often, premiums of out-of-the-money
options can be distorted greatly; for example, in April-May 1994, soybean
ratio spreads provided a high probability of profit because the volatility for
the out-of-the-money calls was double the volatility of the at-the-money
calls. This scenario can lead to significant opportunities. When options
approach expiration, volatility for all the strike prices tends to equalize. In
this instance, if you purchase the most fairly priced calls (near the money),
and sell the most overvalued calls (out-of-the-money), you could expect the
options sold to lose premium faster as the market moves in either direction.
Even if the market were to move higher (unless making a straight-up vertical
move), this spread would also work as the nearer-to-the-money option would

12
gain in value faster than the already overpriced out-of-the-money options.
Another overlooked characteristic of volatility is that it tends to drop
gradually, then level off; however, volatility increases can be characterized
by very sharp changes driving option premiums to extremely high levels.
These events occur rarely, but when they do, they can be very damaging to
those holding short option positions. An example of this was the volatility
increase in many stocks at the beginning of the Gulf War. Oil volatility
doubled, while other markets such as gold, bonds, and currencies increased
20% or more. Even in seemingly unrelated markets such as cattle, volatility
increased dramatically.

Figure 5
Quickly rising volatility in crude oil caused option premiums to expand to very “overvalued”
levels.

Changes in volatility affect the premium levels in options that are going
to be purchased, as well as those already purchased or sold. An example of
this is crude oil and the S&P 500 option markets where volatility has ranged
between 20% to more than 100%.
With high volatility, if one were to purchase an out-of-the-money option,
he would need a substantial price rise before that option would be profitable
at expiration. Both the expense of the purchase price of the option and time
value would be working severely against him; however, with volatility at
lower levels, this option would not only cost much less, but it would also
require a smaller move for the position to be profitable. This is because,
many times as prices begin to rise, volatility also increases, thereby increasing

13
the premium of the option purchased.
Option volatility can also alert the trader in advance to significant market
moves. When option volatility is at low levels, there is a high probability that
a large move is about to occur. Often, when a contract is very quiet, traders
seemingly “fall asleep,” not expecting anything to happen. Of course, this is
exactly when everything explodes!

Figure 6
Again, in this case, historically low option volatility provided an advance indication of an
impending breakout. (We wait for the market to tell us which way it wants to go before
jumping on board!)

The concept of option volatility and the time decay characteristic of

options are the two most important and overlooked factors in option trading.
These concepts can be difficult to learn and use, but their proper use can
result in a “trading edge” over the markets.
When trading options, one must learn to be flexible, using what the
market gives to best advantage. Sticking to one strategy may not be
appropriate for current conditions. Changes in volatility levels require the
use of different option strategies depending on the relative level of volatility
in the option and underlying market as we discuss in th upcoming chapters.
14
 CHAPTER II
WHEN TO USE OPTIONS

The Trading Edge

Options should be used instead of outright futures contracts whenever

the trader can realize a “trading edge” or advantage. They are advantageous
whenever they offer a higher mathematical probability of profit; less risk of
sudden, unpredictable, adverse market moves; a better risk/reward ratio;
and/or increased trading opportunities.

1. Higher Probability of Profit: Through the proper use of option

premiums, positions can be constructed that offer a high probability of
profit. For example, selling an out-of-the-money, overvalued call on an
overvalued, overbought commodity, or buying an at-the-money put in
the same situation. A simple method of detecting an undervalued option
is to compare current volatility to past readings. This can determine
whether the volatility is at the high or low end of its range, commonly
referred to as “theoretically under- or overvalued.”

2. Less Risk of Sudden, Unpredictable, Adverse Market Moves: Option

buyers may insulate themselves from large, unlimited losses that occur
from overnight adverse moves by using one of many limited-risk option
strategies. Options can also be used to prevent being “stopped out”
intraday on a trade that later would become favorable. Even close-only
stops (stop orders to close out positions in the closing range if the contract
reaches a predetermined loss level, ignoring intraday price movements),
may inflict losses when the contract is limit up or down against the
trader. As most futures contracts are subject to daily price movement
limitations beyond which a trader cannot exit his position, he may find
himself “locked in” for another day, which may be another limit day.

By using limited risk option net and spread positions, a trader may greatly
reduce his trading risks. In such option positions, risk is limited only to the
premium paid for the option position plus commissions and fees. Because
the option trader has 1) a predetermined risk, and 2) is not subject to being
“stopped out,” he has more time to properly evaluate his position when
there are sudden changes.
15
3. A Better Risk/Reward Ratio:

By selling overvalued and/or buying

undervalued options, trades may be initiated to take
advantage of disparities in option premiums.

Temporary inefficiencies in the market may provide the trader some of

the most significant trading opportunities with exceptionally high
mathematical probabilities of profit.

4. Increased Trading Opportunities: Option strategists may enjoy

opportunities that do not exist with outright futures positions lacking
trend or having too much volatility. Moreover, option strategists are the
only traders who can initiate trades to profit in flat, trendless markets.
In fact, such markets provide the option strategist opportunities with
some of the highest mathematical probabilities of profit, such as “Neutral
Option Positions.”

When To Buy Options

Because an option contains time value, the purchaser of an option is

buying a “wasting asset” that is declining in value. Option purchases,
therefore, must be restricted to special situations. One of the best
circumstances is when volatility is low and the trader’s system or the market
is likely to face a change of direction. An option purchase allows the trader
to take a position with a limited risk of loss; however, unless a significant
market move occurs, the trader should have set objectives that permit him
to close out this position before time decay erodes the option premium.

Here are a few points to remember:

1. Options that are close-to- or in-the-money are more likely to be profitable

than out-of-the-money options. You must have almost perfect timing to
make money with far out-of-the-money options. Out-of-the-money
options offer enormous leverage for big moves only.

16
2. Options are usually cheaper after market declines or in flat markets,
and relatively more expensive in bull markets. Small traders generally
prefer to take a long position by purchasing calls; they have less demand
for puts, thus, calls are usually more expensive than puts. The public
prefers to be “long” and is predominantly buyers of call options.

When To Sell Options

Option sellers appear to be at a great disadvantage because their reward

(profit) is limited to the premium they collect, while their loss is potentially
unlimited.

However, the mathematical odds favor the

option seller for several reasons.

First, option sellers have mathematical probability in their favor because

options are usually overpriced. Options are often overpriced compared to
fair value formula pricing because of the nature of the participants in the
market.
Second, in addition to their being overpriced, the seller of calls has a
further advantage in that he will profit if the market is flat, moves lower, or
even if it moves slightly against him (higher). Only if the market moves
swiftly and sharply against him will the option seller lose.
Third, by selling out-of-the-money options containing only time value,
the options continually lose time value and, therefore, some of their premium.
Because naked option selling potentially entails an unlimited risk of loss,
the trader should not only have predetermined parameters for taking profits
and accepting losses, but also confine trading to market conditions that are
most favorable, such as over bought/over sold markets, high option premi-
ums, etc. The trader should carefully monitor his positions.

17
 When To Use Options with Futures

Options may be purchased to protect a futures position instead of us-

ing stop loss orders; for example, a trader who is bullish on gold purchases
the the futures contract at 320. At the same time, a December 320 gold put
is purchased for $500. In this case, risk is limited to $500 (plus commissions
and fees), and the futures position can be held no matter how severely the
market goes against it.
“Covered writing” of futures positions is also one of the best, most
conservative, and overlooked of all option selling strategies. This is discussed
in greater detail in Chapter 8.

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 CHAPTER III
OPTION SPREAD STRATEGIES

There are virtually unlimited possibilities for different option trading

strategies by combining puts and calls on any given commodity using different
strike prices or different expiration dates. Such strategies are used not only
by companies specializing in the arbitrage of options and using sophisticated
computer analysis, but also by investors at home with pen and pad, developing
their own individual trading strategies. Options strategists also use technical
and fundamental analysis of the underlying market, computer analysis of
option premiums and risk/reward ratios, and return on investment calculations
that boost profit potentials.

When two or more options are

combined into one strategy,
they are called a spread.

Combinations may serve to reduce risk and increase the probability of

profit. They may be used in bull markets, bear markets, flat markets, and
volatile markets. Complex strategies range from spreads profiting from
disparities in option premiums to spreads that benefit solely from time premium
decay.
FUTURES CHARTS
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Figure 7
We compare option volatility readings to determine whether option volatility is relatively high
or low, to know whether we should be considering option buying or selling strategies.

19
Option Strategies that Provide the Trader with a
Significant Advantage

1. Neutral Option Position—High–medium option volatilities/

trading range market (sell out of-the-money put and
out-of-the-money call of the same expiration month). The Neutral
Option Position is best used in markets that have extremely high
premium (by selling far out-of-the-money options), and trading range
markets at any volatility level that have little likelihood of significant
movement.

2. Free Trade—Low option volatility trade/trending market (buy

close-to-the-money call or put and, if the market moves in the
direction indicated, later sell much farther out-of-the-money call
or put at the same price). The Free Trade is used in trending markets
to purchase options of low to medium volatility that are close to the
money (particularly on pullbacks or reactions against the trend). Farther
out-of-the-money options which can have much higher volatility levels
are sold on rallies to complete the Free Trade.

3. Ratio Option Spread—Premium disparity between option strike

prices, high volatility in out-of-the-money options/mildly trend-
ing market (buying close-to-the-money option and selling two or
more farther out-of-the-money options). The Ratio Spread is used
when disparity in option premiums exists. This generally occurs in ex-
tremely high volatility markets such as gold, silver, and soybeans. In
this case, the close-to-the-money option is purchased and two or more
farther out-of-the-money options (which can have up to twice as high
option volatility levels) are sold.

4. Calendar Option Spread—Premium disparity between option

months, high volatility in close-to-expiration options (sell
close-to-expiration month, buy deferred month in the same option).
The Calendar Option Spread is used to take advantage of disparities
in volatility between contract months of the same option. The trend is
not significant for this position as long as we feel the option we sell will
probably not be “in-the-money” at expiration.

5. In-the-Money Debit Spread—Premium disparity between strike

prices/trending market (buy in-the-money or at-the-money option

20
 and sell farther out-of-the-money option). The In-the-Money-Debit
Spread is initiated in volatile markets that are trending. Similar to the
ratio spread, the at-the-money option which is more fairly valued is
purchased and the farther out-of-the-money overvalued option is sold.

6. Free Option Position—Higher option volatility in

out-of-the-money options take advantage of strong technical
support and resistance levels (buy near-money option, sell out-
of-the-money put and call). The Free Option Position allows you to
purchase an option with the premium received from selling other options.

You may want to use other positions or invent complicated multi-legged

positions, but we have found those described above to be effective ones
that can be used practically by off-floor traders to provide a significant
advantage.
In the following chapters, we describe the situations where we use
these positions, how to manage these positions, and we look at examples of
how they have worked in the past.

21
 CHAPTER IV
USING NEUTRAL OPTION POSITIONS

The Neutral Option Position is a trading strategy that provides the

trader with many benefits over a long or short futures or options position.
While option purchases and futures trades are only successful if the market
moves in the direction predicted (without the trader being “stopped out”
first), a Neutral Option Position can be successful in a non-trending mar-
ket or a choppy market (studies have shown that markets are in a
non-trending or sideways pattern almost two-thirds of the time) or if the
market moves slowly lower or higher.
In addition to allowing the trader to be successful without having to
predict the exact direction of the market, the Neutral Option Position
incorporates the advantages of:

1. Special Circumstances 4. Mathematics

2. Price Disparity 5. Probability
3. Option Time Decay 6. Money Management

This strategy involves selling an out-of-the-money put and an out-of-

the-money call containing only time value, with the expectation of collecting
the entire amount of time value premium as the underlying futures remains
within a wide trading range.
We are, in effect, taking the other side of trades from participants on
both sides of the market who are attempting to pick the direction of the
underlying futures contract. Some feel that the market is going up, while
others believe that the market will head lower. The traders who feel that the
market is going up purchase calls, while those negative on the market
purchase puts.
We, in effect, are staying evenly balanced in our positions; however, we
have an advantage in doing so. With our Neutral Option Position we can
profit on both sides of the market (if the market stays within our predicted
or adjusted trading range).
For example, with treasury bonds trading near 113, we can take the
view that the market is going to remain within the range between 110 and
120 and sell the 110 put and the 120 call.
These options are sold to other traders who were acting on their prediction

22
of market direction—that the market was going below 110 (puts) or above
120 (calls). We were making no predictions other than that it would remain
in a wide trading range.

Neutral Option Position

(110 Put—120 Call)

Market Price

Every day, both options sold lose some of their time value. Further,
adjustment techniques are available, allowing us to “rebalance” this position
when necessary. Remember, there is always unlimited risk of loss when an
option is sold, so risk management is always important.

23
 Figure 8
Adjustment of Neutral Option Position when futures approaches strike price or option sold.

The benefits of this position include:

1. Not having to predict market direction.

2. Being able to profit from both sides of the transaction—both from the
buyers of puts and buyers of calls.

3. Being able to take advantage of the “overvalued” time value of out-of-

the-money options because, while the amount of option premium changes
from time to time, traders continue to buy options, thinking they can
“beat the market.”

4. We can increase the number of positions based on favorable market

conditions (high option premium), and we have forty different
commodities from which to choose for the sale of options.

5. Finally, we have the ability to both adjust our positions and increase our
position size. It has been mathematically proven that with sufficient
capital, the probability of making a profit becomes greater.

24
 CHAPTER V
THE “FREE TRADE”

The free trade combines the best principles of money management

and the advantage of “undervalued” and “overvalued” options; however,
the most exciting aspect of the free trade is that it allows you to build a
large position in a trending market without increasing your initial risk.
To initiate the free trade, first purchase the best-priced option. When
(and if) the price and volatility (premium) rise, sell a farther out-of-the-money
option at the same price. Of course, if the market does not move in your
favor, you cannot complete the free trade. Another benefit of the free
trade is that after it is completed, there is no margin capital necessary, or
potential loss (other than brokerage fees and costs). For example, in February
1994, in bonds (see top of chart 8a), you could purchase the 112 and 110
puts. Thereafter, the market continued to decline (see bottom of chart 8a),
and you could sell further out-of-the-money options, such as 106 and 108
puts at the same price as we purchased the 110 and 112 puts.
For example, if you purchased the 112 put and paid 32 ($500) and there-
after sold the 106 put for the same amount, you would then have a position
that had a net cost to you of $0 (except for commissions and fees) and a
profit potential of $6,000.
11900
11700
11500
11300
11100
10900
10700
J A S O N D 94 F

11800
11500
11200
10900
10600
10300
O N D 94 F M A M
Figure 8a

25
The free trade accomplishes several objectives:

First, it keeps your account intact if the market turns around. Just as
quickly as markets rise, they can also fall. The free trade position provides
protection from loss in this situation.
Second, if the market moves in your favor, you can continue to add to
your position on the next pullback. If the trend remains intact and the market
pulls back, as it eventually does, you are then in a position to purchase
another option to begin building a larger position. You can look to turn the
second position into a free trade using the same method without increasing
your initial risk. By doing this you can take advantage of the normal swings
of the market to purchase options when they are the cheapest and sell them
when they are the most expensive, on rallies. Further, you will be purchasing
“closer-to-the-money options” which are normally the most fairly valued
options, and selling “out-of-the-money options” which are usually the most
overpriced options.
Also, the collateral benefits of the free trade—being able to look at
other potential opportunities because this position is secure from loss and
requires less monitoring, and the emotional security of having your equity
protected—should not be overlooked.
Another benefit of the free trade is that it gives you time to unemotionally
examine your position without the panic other traders experience as their
profitable positions begin to nose-dive. Because you are protected, you can
wait for emotions to subside and the market to give you a better indication
of its next move. You can then decide to hold your position and look for full
profit potential (knowing you are completely protected from loss), or you
can cash out and take your existing profits.
The final benefit of free trades is that, when they are completed, because
your capital is protected, you can turn your attention elsewhere. You may
find opportunities in another commodity, or even in the market in which you
have completed free trades to add more positions. This can be accomplished
without increasing your original risk because your first positions are now
risk-free! It is difficult to closely monitor more than two or three net positions,
especially in volatile markets. The free trade allows you to concentrate
more fully on other situations.
The free trade also allows you to meet your objective of getting a
“trading edge” over the markets by using options. You are taking advantage
of the increased volatility of the out-of-the-money options, which can be
quite exaggerated on market rallies.

26
 CHAPTER VI
THE “RATIO SPREAD”

A ratio spread is initiated by purchasing a close-to-the-money option

and selling two or more farther out-of-the-money options. For example,
with November soybeans trading at $6, we may decide to purchase a
November $7 call and sell two $10 calls. Let’s assume that the $7 call is
trading at a premium of 20 cents and the $10 call at a premium of 12 cents.We
would then pay 20 cents for the $7 call ($.20 X $50 = $1000); and receive
two times 12 cents or 24 cents for the $10 calls we sell ($.24 X $50 =
$1,200). In this case, because we receive $200 more than we paid out, we
are doing the spread at a credit of 4 cents, or $200.

FUTURES CHARTS
COURTESY FUTURESOURCE
(800) 621-2628

Soybean Futures Price

Figure 9
- The probability of the futures price achieving a given price level.
—The profit or loss potential of a soybean ratio option spread comprised of 1 long
$7.00 call and 2 short $10.00 calls receiving a credit of $200.

27
Receiving this credit is very important when doing the ratio spread, and
beneficial for the following reasons:

1. First, if the market goes up as we expect in this example, we will receive

a profit of $50 for every penny soybeans move over $7.00 at expiration
(up to $10) for a maximum profit potential of $15,000.

2. Unlike a normal option purchase, there is no cost for your initial option
purchase because it was paid for by the sale of the two $10 calls.

3. In making this trade, we are also taking advantage of the disparity in

option premiums between strike prices. We find in most markets options
that are closer-to-the-money have lower volatility (premium costs) than
farther out-of-the-money options.

These out-of-the-money options have no intrinsic value because they

have only what is known as “time value premium.” This is a specific
amount people will pay for an option because it has a chance of becoming
valuable some time in the future.

There is more demand by smaller traders to purchase “cheap” options.

This can greatly increase the time value of these out-of-the-money
options to a point where they, at times, are much more expensive than
one might expect. Because the options are so far out-of-the-money, it
is very unlikely that the options will go into-the-money, yet the premiums
do not reflect this lack of probability. Thus, they are, relative to the
probability of profit, much more expensive than the close-to-the-money
options. By using the ratio spread we can take advantage of this
disparity in premium because it allows us to purchase the more reasonably
priced close-to-the-money option and sell the relatively more expensive
options that are farther out-of-the-money.

4. The farther out-of-the-money options we sell will also lose their time
value faster as they approach expiration. Time value decreases for
both an option at-the-money and out-of-the-money as it approaches
expiration. This decline in time value is much more dramatic for the
out-of-the-money option.

5. Finally, one of the biggest benefits of the ratio spread, is the fact that,
if the market does not move as expected, as long as we obtain a credit

28
 when the spread is initiated, we will not have a loss. In our example
above, let’s assume that soybeans drop to $4. In that case, the options
we purchased and sold will all be worthless at expiration. At that time,
the net difference to our account from taking this position will be the
$200 premium that we collected when we initiated this position; therefore,
our account will increase by $200 (less commissions and exchange
fees) even though the market moved against us!

There is only one case where the ratio spread can run into trouble:
when the price of the futures exceeds the strike price of the options sold.
For example, in our previous discussion of the soybean ratio spread, if at
expiration in November soybeans expire at $10, we make 300 points times
$50, or $15,000; however, if the price of soybeans exceeds $10, we begin to
lose $50 of our profit for each penny that soybeans exceeds $10. At the
price of $13, we would break even on this position, and over $13 we would
begin to have a net loss of $50 for each penny move that exceeds the price
of $13.
To help control the potential for large losses under these conditions, we
follow a rule that requires us to close out our ratio spread if the futures
price exceeds the strike price of our short option; therefore, if soybeans rise
above $10 at any time, we would recommend closing out the position.
We normally find that if the market rises slowly toward the strike price
of the options we sold, we still have a profit on the position when we close
it out. Usually, only in the case of a quick rise is it necessary to close the
position out as a loss.
The best time to initiate a ratio spread is when the market has made a
quick straight-up move. This is because this type of action normally increases
the demand for out-of-the-money “cheap” options for the reasons mentioned
above. This also seems to be when there is the greatest disparity in premiums
between the close-to-the-money and the out-of-the-money options, providing
the best opportunity for ratio spreads. (The one exception currently is the
S&P 500, when put option premium expands on market declines.)
We feel that the benefits of the ratio spread far outweigh the single
problem area, that of the market rising too quickly, too soon. Also, these
problems are handled by the rules we described above. The ability to initiate
a spread that can be profitable over a wide range of prices and market
conditions (in the case of our soybean example this position is profitable
from $0-$13!) allows you to have both financial and emotional security in
the markets.

29
 CHAPTER VII
THE MOST OVERLOOKED OPTION BUYING
STRATEGIES (DON’T TRADE ANOTHER FUTURES
CONTRACT UNTIL YOU READ THIS!)

1. The In-The-Money Debit Spread

The In-the-Money Debit Spread consists of purchasing an in-the-money

option and selling an out-of-the money option of the same expiration month.
It is a position that requires us to pay a premium—the cost difference be-
tween the option we purchase and the option we sell—in exchange for
potentially receiving the difference between the two strike prices.
For example, currently, the September S&P is trading at 1260. A trader
who is bearish on the S&P could purchase the September put 1260 for
4000 points ($10,000) and sell the 1240 put for 2800 points ($7,000) for a net
cost or debit of $3000. The potential profit on this position is the difference
between these two strike prices 1260 minus 1240, 2000 points ($5,000) less
the initial cost of the option.
As uninspired as this position may seem, it actually has substantial ben-
efits over a short futures position including:

1. Lower cost
2. Limitation of risk
3. Ability to take advantage of premium disparity.

The cost or debit of the September S&P in-the-money debit spread in

this example is $3,000; however, the margin for initiating a short futures
position is substantially higher, at more than $10,000. This allows a trader to
commit less of his capital to any one trade.
The second, and probably more important advantage, is limitation of
risk. While a short futures position burdens the trader with unlimited risk,
the risk of the In-the-Money Debit Spread is absolutely limited to the
amount paid for the spread plus commissions and transaction fees. This can
be more of a substantial benefit than most traders realize. Even though
many futures traders feel that they can limit their risks by the use of “stops,”
what is not taken into account is that many times, they can be “stopped out”
because of the risk of taking a large loss in a market that has begun to make
a big move against this position only to then see the market reverse and

30
move in their favor. With the In-the-Money Debit Spread the trader knows
that not only is his risk limited, but he is actually hedging some of his losses
if the market goes against him with the gains on the option he sold.
These factors can be very important, especially to a trader who finds
that, although his ability to predict market direction is good, he is emotionally
and financially unable to handle the normal market “noise” of corrections,
even when the market is trending in his favor. This psychological advantage
of knowing that your losses are absolutely limited can make the difference
between a winning or losing trade.
The third benefit of this position is being able to take advantage of
disparity in option premiums. In the spread described above, the volatility of
the 985 was less than that of the 965 put. This means that we were selling
an option that was trading at a volatility higher than the option we were
purchasing, providing another significant benefit.
The advantages of this position seem so overwhelming that one wonders
why anyone would trade the outright futures contract. Still, there are some
disadvantages that should be considered by all traders before they initiate
this position. First, we are initiating a spread of two positions instead of one,
so there is an extra commission for each trade. Second, orders should always
be placed at a specific limit price to avoid slippage that can occur with less
liquid options. Third, profit on a “Debit Spread” is limited, as opposed to the
unlimited profit potential of futures positions; however, we feel that these
disadvantages are a small price to pay for the benefits that accrue with this
type of position, and could make the difference between a profitable or
unprofitable trade.

2. Option Straddle Purchase

This “non-directional” option strategy is also greatly overlooked. The

Option Purchase Straddle is the purchase of a put and a call of the same
month and underlying market. As in all option purchasing strategies, we
recommend that at-the-money or close-to-the-money options be used. Similar
to the In-the-Money Debit Spread, risk is absolutely limited to the premium
paid for the options plus commissions and transaction fees; however, not
only is the potential profit unlimited, but we can also profit by a move in
either direction. This is why we call it a non-directional option strategy—we
don’t care which way the market moves, as long as it moves.
Since this strategy will be unsuccessful only if the underlying futures
contract does not make a significant move in either direction, we only
recommend initiating this position during the following times:

31
1. Before important reports, meetings, and releases of information that
could substantially affect the futures prices in either direction;
2. When option volatility (premium cost) is low; or
3. When the futures’ technical pattern suggests a large breakout is
imminent.

This strategy was recommended in July, 1997 just prior to the G-7
meeting. We expected these meetings to have a severe impact on the
currency market, either by action or disappointment from non-action. Further,
the option volatility in the D-Mark was near historical low levels in spite of
large daily moves occurring in the underlying futures market. This strategy
worked well as the D-Mark jumped almost 200 points the day after the
meetings concluded, allowing traders who initiated this position to turn their
call purchases into Free Trades. In fact, since the market began to turn
around right after this jump, the puts began to gain significantly in value, and
on a continued move down, traders were in a position to turn the puts into
Free Trades. This is the ultimate of all positions, to have a Free Trade in
both directions, and be able to profit without having to pick market direction!

FUTURES CHARTS
COURTESY FUTURESOURCE
(800) 621-2628

Figure 10

This is a triangle pattern in December Oats.

32
 This position is also recommended when the market has moved itself
into an explosive chart pattern. Our favorite type of chart pattern for this
position is the “triangle” pattern, where the futures have made lower highs
and higher lows over an extended period of time. The market then “coils”
itself into a tighter and tighter trading range from which a large breakout
always occurs. The problem is in guessing which way this move will take
place. The option straddle removes this question, allowing the investor to
profit by a large move in either direction. Further, this is normally an
opportune time to purchase options, as volatility often falls to very low levels
as the market “quiets down” and moves into this trading range. Then, after
the breakout, not only does the option gain from the price movement, but
volatility can increase substantially thereby also further increasing the value
of the options purchased.
These two positions are not only the most overlooked option purchasing
opportunities, but they are strategies that can provide the investor with
significant advantages in the right circumstances—a substantial “trading
edge” over the markets.

33
 CHAPTER VIII
THE MOST OVERLOOKED OPTION
SELLING STRATEGIES

We have discussed the benefits of the Neutral Option Position (which

is our favorite option strategy for choppy, flat, or non-trending markets) and
the Ratio Option Spread, one of our favorite option strategies when
out-of-the-money option premiums are extremely overpriced; however, two
positions that have great benefits in many situations, Covered Call Writing
and Calendar Spreads, are also often overlooked. These overlooked
strategies can provide a trader with overwhelming advantages when used
in the right circumstances.

1. Covered Call Writing—Additional Income; No Risk or Margin

This strategy is one of the best methods of increasing your returns

without any additional risk, margin, or capital necessary. This strategy is
initiated by selling an out-of-the-money option against a futures position.
For example, a trader purchases a silver futures contract at $4.50. At the
same time, he sells the September $5.00 call for $300. There is no additional
cost or margin for this position because the calls you sell are “covered” by
the long futures position. Thereafter, the market can react in four ways:

a. It can move lower;

b. It can remain stable;
c. It can move higher, but remain below $5.00;
d. It can move above $5.00 (an increase of over 11%).

In the first three instances, the net effect of initiating the covered call
would be to add a risk free $300 to our account to lower our losses in
situation a), or increase our profits in situations b) and c). Even in situation
d), which is the only scenario in which writing a call would be detrimental to
us, the only loss here is the limitation of potential profits (an opportunity
loss) above the $5.00 price. Our initial profits of $2,500 in the futures plus
the $300 we received for selling the option (less commissions and fees)
would be ours to keep. We just would receive no additional profits if silver
really took off and continued to move substantially above $5.00.

34
 There is also a variation of covered writing that can provide the investor
with a more aggressive position with additional profits in a trending market
situation. In this case, after purchasing the silver at $4.50, you also purchase
a $4.50 call and sell two $5.00 calls. Our existing position now is long one
futures contract of silver at $4.50, long one silver $4.50 call; and short two
$5.00 calls. In this situation, our maximum profit level is $5,600 if silver is at
$5.00 by September, instead of the $2,800 that we could make if we purchased
only the futures without the aggressive option strategy. In fact, silver would
have to go all the way from $4.50 to $5.50, a move of more than 22%, to
make as much money with the futures alone as we would make with the
aggressive option strategy. What’s more, only above $5.50 does this strategy
become detrimental to us, as profits are limited above this level.

In summary, this option strategy works as follows:

1. If silver moves under $4.50, there is no detriment from this strategy

(except for commissions and fees);

2. If silver moves above $4.50, but remains at or below $5.00, our profits
will be double what we would make with a futures position alone;

3. There are additional profits for traders while silver is between $4.50
and $5.00, above those that would be made on the futures alone; and

4. Only above $5.50 are profits limited (however, by this time we would
have made $2,800 for each option strategy and futures purchase).

2. Calendar Option Spread—Take Advantage of Disparities in Fu-

tures and Options Price

The Calendar Option Spread is initiated by purchasing a deferred

month option and selling a closer-to-expiration option. The advantage of this
position is the steep time decay that close-to-the-money options undergo.
This in itself is a substantial advantage to an investor; however, there are
two additional situations when this trade turns the odds overwhelmingly in
favor of the option strategist. The first is when option volatility for the closer-
to-expiration months is trading at substantially higher levels than the deferred
option. This happens in volatile markets, as there is an increased demand
for these “more active” options for speculation and hedging. Often, we find

35
that the deferred month options are “forgotten” and trading at volatility
levels 50% or more below the active front month option. Examples of this
occurred in 1996–1997 in the cocoa and coffee markets when they began
to break out; in the grains during their rally attempt this spring, where front
month premiums were higher; and in live cattle in May and June after it
rallied to new highs.
One of the best instances illustrating the benefits of this strategy occurred
in the live hog option market. The spread between February and October
live hogs had moved from February being 100 over October in the beginning
of June, to February being more than 150 under in July. Our research showed
that this does not happen often and usually such a disparity in the futures
contract is quickly corrected. Additionally, because of the volatility in the
live hog market, the February calls were 20% less expensive than the October
calls; therefore, we recommended a Calendar Spread to purchase in-the-
money February call options while selling out-of-the-money October options
that were close to expiration and entering a period of their most severe time
decay. This trade combined the best of both worlds for the Calendar
Spread allowing:

1. the trader to take advantage of the undervaluation of the deferred

month option contract;
2. the overpricing of the close-to-expiration option; and
3. the rapid time decay of the close-to-expiration options.

36
 CONCLUSION
When I began trading options in 1982, I decided that I would read and
study all the books I could find on option trading, so that I could choose
which methods worked best. What I didn’t know was that, if my education
had been limited to this information, my abilities as a trader would have
been strictly limited. While there is no substitute for this knowledge, other
areas, such as having a trading plan and money management principles, are
equally necessary to succeed.
When I began researching option trading, I was very excited because
of the mathematical possibilities of combining options, and what I discov-
ered as certain characteristics that seem to provide significant benefits,
such as premium disparities between option strike prices and time decay of
overvalued options. After reading all existing option material, I felt almost
helpless because there was no “road map” to guide my option trading from
that point. I hope that this booklet can be the beginning point of your “road
map to success.”

DAVID L. CAPLAN
MALIBU, CALIFORNIA

37
 Appendix 1
COMMON OPTION STRATEGIES FOR ALL MARKETS

Option
Spread Best Time
Strategy Position Characteristics to Use

Neutral Strategies

Neutral Option Sell out-of-money Maximum use of Trading range

Position put and call time value decay market with
volatility peaking

Guts Sell in-the-money Receive large Options have time

put and call premium value premium
and market in
trading range

Arbitrage Purchase and sell Profit certain if Any time when

similar options done at credit credit is received
simultaneously

Conversion Buy futures, buy Profit certain if Any time when

at-the-money put done at credit credit is received
and sell out-of-
the-money call

Box Sell calls and puts Profit certain if Any time when
same strike price done at credit credit is received

Butterfly Buy at-the-money Profit certain if Any time when

call (put) sell 2 out- done at credit credit is received
of-the-money calls
(puts) and buy out-
of-money call (put)

Calendar Sell near month, Near month time Small debit,

buy far month, value will decay trading range
same strike price faster market

38
Option
Spread Best Time
Strategy Position Characteristics to Use

Mixed Strategies

Ratio Call Buy call, sell calls Neutral, slightly Large credit and
of higher strike bullish difference be-
price tween strike
prices of option
bought and sold

Ratio Put Buy put, sell puts Neutral, slightly Large credit and
of lower strike bearish difference be-
price tween strike
prices of option
bought and sold

Straddle Buy put and call Options will lose Options under-
Purchase time value valued and
premium quickly market likely to
make a big move

Covered Call Buy futures, sell Collect premium Neutral—slightly

call on calls sold bullish

Covered Put Sell futures, sell Collect premium Neutral—slightly

put on puts sold bearish

Bullish Strategies

Buy Call Most bullish Loss limited Undervalued

option position option with
volatility
increasing

Sell Put Neutral–bullish Profit limited Option over-

option position valued, market
flat to bullish

39
Option
Spread Best Time
Strategy Position Characteristics to Use

Bullish Strategies, Continued

Vertical Buy call, sell Loss limited Small debit,

Bull—Call call of higher bullish market
strike price

Vertical Buy put, sell put Loss limited Large credit,

Bull—Put of higher strike bullish market
price

Bearish Strategies

Buy Put Most bearish Loss limited Undervalued

option position option with
increasing
volatility

Sell Call Neutral–bearish Profit limited Option over-

option position valued, market
flat, bearish

Vertical Buy-at-the-money Loss limited Small debit,

Bear—Puts put, sell in-the- bearish market
money put

Vertical Sell call, buy Loss limited Large credit,

Bear—Calls calls at higher bearish market
strike price

40
 Appendix 2
NEUTRAL OPTION SPREAD STRATEGIES

1. Neutral Strategy (sell put–sell call)

Requirements:
1. Sell out-of-the-money put and out-of-the-money call
2. Choose options as far out-of-the-money as possible, but still collect
worthwhile premiums
3. Contract volatility high, but decreasing
Example:
With bonds at 113 and in a range of 106 to 116 , sell the 120 call and 102 put.

2. Calendar Spreads (buy far month–sell near month)

Requirements:
Option premium lower in deferred month; equivalent or nearly equivalent
out-of-the-money options at smallest net debit or at any credit.
Example:
With July sugar at 12 cents and October sugar at 12.75 cents:
Sell July 13 cent call .75 cent
Buy Oct.13 cent call 1.00 cent
2.50 cents debit and a difference
of .7 cent between
futures month prices.

3. Calendar Combination (combine calendar and strangle)

Example:
With July sugar at 12 cents:
Sell July 14 cent call Sell July 10 cent put
Buy Oct. 14 cent call Buy Oct. 10 cent put

4. Ratio Spread (buy close-to-the-money call or put—sell out-of-

the-money call or put)
Requirements:
1. Large spread between strike prices of options bought and sold
2. Premium received is greater than premium paid
3. Futures price is not likely to reach strike price of options sold
4. High premium for out-of-the-money options sold
Example:
Buy 1 July 12 cent call—Sell 2 July 16 cent calls

41
5. Ratio Calendar Spread (combine ratio and calendar)
Requirements:
1. Large spread between options bought and sold
2. Zero premium or small debit
3. Futures price not likely to reach strike price of options sold
Example:
Buy 1 Oct 12 cent call and sell 2 July 14 cent calls

6. Ratio, Calendar and Strangle Combination

Example:
Buy (1) March 14 cent Sell (2) March 16 cent
sugar call sugar call
Sell Dec 16 cent Sell March 12 cent
sugar call sugar put

7. Butterfly (ratio spread plus purchase of an out-of-the-money

option)
Example:
Buy call or put
Sell 2 calls or puts (Strangle or Straddle)
Buy call or put
Example:
Buy Call
Sell call and put (Straddle or Strangle)
Buy put

8. Conversion (buy futures, sell out-of-the-money call(s), and buy

at-the-money put)
Requirements:
1. Look for an at- or close-to-the-money put with a premium equal to
the debit on an out-of-the-money call (possible because calls are
usually valued higher than puts).
2. Use when market has declined and calls are overvalued
Example:
Buy Sep. futures
Buy Sep 925 put for 3000 points
Sell Sep 930 call for 3000 points
(Risk = debit if put is at-the-money)

42
 Appendix 3
OPTION STRATEGY SUMMARY
Strategy/Characteristics Requirement for Profit

PUT PURCHASE—High cost/risk is loss of option premium; Loss of premium results unless significant downside
reward limited to prevention of loss of stock or bond portfolio move occurs.
value; requires good skill in timing and premium evaluation.

CALL SALE—Reward limited to premium received; limits Will add income to portfolio in flat or limit profit of
profit bear market, but can potential of underlying portfolio, underlying positions in a bull market.
requires good skill in timing and premium evaluation.

SELL FUTURES—Unlimited risk/reward requires maximum Can provide hedge against loss in a declining market, but

43
skill in timing. can limit profit of underlying positions in a bull market.

STRANGLE SALE—Reward equal to amount of premiums S&P 500 remains in trading range of puts and calls sold.
collected. High mathematical probability of profit; does not
require prediction of market direction; requires good market
monitoring and premium evaluation skills.

BUY PUT/SELL CALL—Eliminates for downside risk without Excellent strategy portfolio after significant market rally
premium cost; does not require prediction of market direction or to lock in profits.
monitoring.

RATIO WRITE—Reward equal to premiums collected; high Best used after significant rally to add return to portfolio.
probability of profit; requires monitoring of extra short
options.
 Appendix 4
GLOSSARY OF OPTION TERMS
ARBITRAGEUR Someone who simultaneously buys and sells
the same or equivalent options in different mar-
kets.

ASSIGNMENT The notice to an option writer that the option

has been exercised by the option holder.

AT-THE-MONEY An option with a strike price equal to the mar-

ket value of the underlying futures.

BETA A measure of how an option’s price move-

ment correlates to the movement of the option
market as a whole.

CALL OPTION An option which gives the option buyer the

right to buy the underlying futures contract at
a specified price within a certain time, and the
seller of the option the obligation to sell the
futures at the strike price if exercised by the
buyer before the expiration date of the option.

COVERED OPTION An option written against an opposite position

in the futures market.

CREDIT Money received from the sale of options.

DEBIT Money paid for the purchase of options.

DELTA The amount by which an option’s price will

change for a unit change in the underlying fu-
tures price. An option’s delta may change from
moment to moment as the option premium
changes.

EXERCISE The action taken by the holder of a call option

if he wishes to purchase the underlying
commodity, or by the holder of a put option if
he wishes to sell the underlying commodity.
44
EXPIRATION The date on which the option contract can no
longer be exercised, and therefore becomes
worthless.

HEDGE Buying and/or selling offsetting positions to

provide protection against an adverse change
in price.

IN-THE-MONEY Describes a call with a strike price lower than

the futures price, or a put with a strike price
higher than the futures price.

INTRINSIC VALUE The amount that an option is in-the-money; i.e.,

futures price minus strike price for calls, or
strike price minus futures price for puts.

MARGIN The sum of money which must be deposited

and maintained by an option seller or futures
seller.

NAKED WRITING Writing a futures option for which the writer

has no underlying futures position.

OUT-OF-THE-MONEY An option with no intrinsic value—a call option

with a strike price higher than the futures price,
or a put option with a strike price lower than
the futures price.

PREMIUM The price of an option contract.

PUT OPTION An option which gives the buyer the right to

sell the underlying futures contract, and the
seller the obligation to deliver the futures
contract at the strike price on or before the
expiration date, if the buyer exercises.

SPREAD A position consisting of two or more options.

45
THEORETICAL VALUE The price of an option as computed by a
mathematical model such as the Black-Scholes
Model.

TIME VALUE The amount of an option’s premium exceeding

the option’s intrinsic value. The premium for
out-of-the-money options is all time value.

VOLATILITY A measure of the change in the price of a

futures contract over a period of time.

2005-CINV-00588

46