Commodity options: trading and hedging volatility in the world's most lucrative market

285 Pages·2009·8.06 MB·English

by  Garner, Carley;Brittain, Paul

Commodity
Options
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Commodity
Options
Trading and Hedging Volatility in the
World’s Most Lucrative Market
Carley Garner and Paul Brittain
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©2009 by Pearson Education, Inc.
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Printed in the United States of America
First Printing January 2009
ISBN-10: 0-13-714286-2
ISBN-13: 978-0-13-714286-6
Pearson Education LTD.
Pearson Education Australia PTY, Limited.
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Library of Congress Cataloging-in-Publication Data
Garner, Carley, 1977-
Commodity options : trading and hedging volatility in the world’s most lucrative market / Carley Garner and
Paul Brittain.
p. cm.
Includes index.
ISBN 0-13-714286-2 (hardback : alk. paper) 1. Commodity options. I. Brittain, Paul. II. Title.
HG6046.G37 2009
332.63’28—dc22
2008026048
This book is dedicated to women in commodities
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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xix
Chapter 1: Option Basics: A Crash Course in Option Mechanics . . . . . . . . . . . . . . . . . . . . . . . . .1
What Is an Option? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1
Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2
Intrinsic and Extrinsic Value: Components of an Option Price . . . . . . . . . . . . . . . . .3
Intrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
Extrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
Time Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6
Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
Trading Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
The Art of Option Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Chapter 2: An Option Is an Option Is an Option…Think Again . . . . . . . . . . . . . . . . . . . . . . . . .11
Options on Futures, aka Options on Commodities . . . . . . . . . . . . . . . . . . . . . . . . .12
Differences in Underlying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12
Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14
Expiration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18
Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18
Nature of Market and Price Movement . . . . . . . . . . . . . . . . . . . . . . . .19
Standardized Point Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21
Stock Splits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
Difference in Option Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Number of Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Technology: Electronic Versus Open Outcry . . . . . . . . . . . . . . . . . . . .23
viii Trading Commodity Options
Independent Futures Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24
Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24
Different Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
LEAPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
Quote Availability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26
Difference in Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26
Long-Term Versus Short-Term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26
Reporting Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
Difference in Regulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
SEC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28
NFA/CFTC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28
Difference in Trading Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28
The Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
Black and Scholes Option Models . . . . . . . . . . . . . . . . . . . . . . . . . . . .32
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34
Chapter 3: Long Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35
Why Long Options Aren’t Always a Great “Option” . . . . . . . . . . . . . . . . . . . . . . . . .35
When to Use Long Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37
Alternative Uses of Long Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38
Factoring in Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39
Long Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
Long Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42
When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42
Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42
Neutral Long Option Plays . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43
Long Straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45
Contents ix
Long Strangle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49
When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49
Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49
Conclusion of Long Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52
Chapter 4: Short Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53
Why Sell Options? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54
Theoretically Unlimited Risk: Option Selling Can Be Hazardous to
Your Wealth! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55
Short Option Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56
The Premise Behind Option Selling . . . . . . . . . . . . . . . . . . . . . . . . . . .57
Preparing to Sell Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .57
Technical Analysis and Option Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58
Option Selling Isn’t Always Appropriate . . . . . . . . . . . . . . . . . . . . . . .58
Reverse Break-Even . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58
The Execution of Option Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . .59
Exercise Me! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .60
The Art of Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
The Double-Out Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
Sell More Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62
Cover with a Futures Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63
Ratio Writes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63
Short Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64
When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64
Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .65
Short Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68
When to Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68
Profit Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68
Option Selling Versus Trading Futures . . . . . . . . . . . . . . . . . . . . . . . .70
Don’t Underestimate the Risk of Illiquid Markets . . . . . . . . . . . . . . . .71