Many traders often start with the simple strategy of buying options. This is a comparatively safe investment approach relative to trading futures outright, and the general idea that the purchase of options limits downside risk to the option premium plus commission and fees is well understood by most. Confusion often arises, however, when trying to understand the movement in price of an option relative to the movement in price of the underlying futures. On a day when the underlying futures moves in a significantly favorable direction, option buyers can be disillusioned by their option values that rise by half, or even less than half, of that amount.

An example will make this clear. On August 17, 2000, October cotton settled up 1.06 cents on the day to 62.70 cents. Shown below are changes in various call and put options based on settlement prices. Changes in option values fall short of changes in the underlying futures. For instance, an individual holding the at-the-money 62 call option saw an increase in value of only 0.44 cents. For those traders holding call options with higher strike prices, the increase was even less.

The sample option prices shown above highlight the following fact:

At-the-money options (whether calls or puts) will move in price by approximately half of the amount of the underlying futures contract. Options that are progressively out-of-the-money (whether calls or puts) will move in price by a lesser and lesser amount, and options that are progressively in the money will move in price by a larger and larger amount. In the extreme, an option which is deeply out-of-the-money will move in price hardly at all when the underlying futures moves, while an option that is deeply in-the-money will move in price by essentially the same dollar amount as the underlying futures. (In this latter case, the deep in-the-money option behaves much like a futures contract.)

The sensitivity of an option's price to a change in the price of the underlying futures is called the delta of an option. That is, for a full point movement in the price of the underlying futures, the delta of an option provides an indication of the corresponding change in price expected for the option. Call options have a positive delta (since call option prices rise with futures prices, and vice-versa) and put options have a negative delta (since put option prices fall as futures prices rise, and vice-versa).

The delta of an option is a consequence of the time value of an option, and it changes as futures prices move and as the option approaches expiration. For the beginner, the important message is that when purchasing options, especially out-of-the-money options that are relatively cheap, a rather large movement in price of the underlying futures will be needed before such options appreciate significantly in value. This should be kept in mind when determining the investment strategy with the best risk/return profile.

Article Reprinted with the permission of Rick Thachuk, of World Link Futures
Rick has been involved in various aspects of the futures and options markets, including positions as an economist and derivatives market analyst at the Bank of Canada and Finex. In 1996, he founded World Link Futures Inc., an educational Commodity Trading Advisor serving the beginning trader.

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