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OPTIONS TRADING STRATEGIES
BUYING COTTON CALL OPTIONS
Let's say that you are bullish on cotton. You have just watched prices recover from a brief sell-off in the past week and this
is the buy signal for which you have been waiting. (See chart at right.) You anticipate that cotton will move higher
in the months ahead and are considering buying a cotton call option to profit should this happen.
The first step of the
purchase decision
is to determine the maturity of the call option: it must be long enough to capture the anticipated price rally.
Since you suspect that prices will move higher over the next several months,
you decide that the
March 2010 cotton call options that
expire in
early February
are a good choice. The second step is determining the strike price.
March cotton call options are available across a wide range of strike prices, each having a different cost.
(See table at right.)
Reading Cotton Option Prices
Cotton options are priced
in cents per pound up to two decimals. One cotton option can be exercised into one
cotton no. 2 futures contract and since each contract is based on 50,000 pounds of cotton, the option price must be
multiplied by 500 to get a corresponding dollar value and every one cent change in the price of the option or the underlying
futures for that matter is worth $500 per contract.
For example, the March cotton call option struck at 73 (or 73.0 cents per pound) settled at 395 meaning 3.95 cents per pound.
The dollar value of this option is 3.95 x 500 = $1,975. This call option is nearly at-the-money
since the March futures contract settled the day at 72.67 cents per pound. Notice that the futures closed
higher over the day by 1.34 cents per pound taking all call option prices higher as well but that the option prices moved by less
than this amount. In fact, this at-the-money call option rose by just 0.36 cents per pound.
As is evident in the table, as the strike price of a call option is raised,
its price declines
as does its sensitivity
to movements in the price of the underlying futures.
Choosing the Strike Price
This requires balancing risk with potential return. The former is simply the cost or purchase price of the option
along with brokerage commission and other trading fees. For example, if you want to risk at most no more than $1,500
on a March cotton call option, then only those options having a strike price of 76 (or 76.0 cents per pound) or higher would be acceptable.
The potential return is based upon your expectation of how far cotton prices will rally. A useful reference is the
break-even price.
The break-even price of a call option
is calculated by adding the option cost and paid trading fees to the strike price.
Consider, for example, the March cotton call option struck at 75 (or 75.0 cents per pound). If it is
purchased at the settlement price shown, then the break-even
price of the March futures at option expiration is calculated as:
75.0 + 3.12 + fee value = 78.12 + fee value.
At option expiration, March cotton futures must be above this break-even price in order to
profit on the option trade.
So, you will only consider call options that have a break-even price below the price to which you expect
cotton will rally. Let's say, for example, that you believe March cotton can reach 82.0 cents per pound by option expiration.
Based on this, you would only consider buying call options having a strike price of 80 (or 80.0 cents per pound) or lower
since otherwise the break-even price is too high.
What remains is the range of acceptable options. In this case, for an investment of at most $1,500 and with an expectation that March
cotton will rally to 82.0 cents per pound by option expiration, the call options having a strike price within the range of 76 to 80
would be acceptable to purchase.
After the purchase, you will need to manage the option position.
What if there are no remaining options that are acceptable after considering your desired risk and price expectation? Then you
can consider buying a more expensive call option and manage the risk, or
you can consider buying a bull call spread.
Bull Call Spread
When buying a bull call spread, both strike prices should be below the price to which
you anticipate the futures will rise by the time the options expire, in this case, 82.0 cents per pound. Based on this, there are several spreads
that can be purchased. For example, the 78/80 bull call spread has a value of 2.26 - 1.82 = 0.44 = $220 plus commission and fees.
If March cotton futures is above 80.0 cents per pound at the time of option expiration, then this spread will close
at its maximum value of $1,000 (calculated as 2 cents x $500 per cent). If cotton is below 78.0 cents per pound,
then this spread will expire worthless.
Stepping down the strike prices will increase marginally the cost of the spread, but the chance of the maximum value
being earned is greater since cotton need not rise so far. For example, the 76/78 bull call spread has a value
of 2.79 - 2.26 = 0.53 = $265 plus commission and fees. March cotton need only be above 78.0 cents per pound at the time of option expiration
to earn the $1,000 maximum value of the spread. If cotton is below 76.0 cents per pound, then this spread will expire worthless.
As you can see, spreads can be constructed at relatively little expense. You can risk more on a spread in return for greater
potential payout by increasing the gap between the two strike prices. For example, the 76/80
bull call spread has a value of 2.79 - 1.82 = 0.97 = $485 plus commission and fees but the maximum value is $2,000
and will be earned if March cotton futures is above 80.0 cents per pound at the time of option expiration.
Because the market for option spreads is generally less active than the market for individual options,
you will likely have to pay a slightly higher price in order to effect the purchase. After the purchase,
you will need to manage the option spread position.
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March 2010 Cotton No. 2 Futures
Settle as of Nov 16, 2009: 72.67 Change: +1.34
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March 2010 Cotton Call Option Prices
Prices as of Nov 16, 2009. Source: The ICE
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