In order to
buy a commodity option
or an option spread, it is first
necessary to open a trading account with a
futures and options broker.
Most brokers offer two general types of trading accounts: self-directed accounts for investors who prefer to trade on their own
usually via an electronic trading platform
and full-service broker assisted accounts for investors who want the support of a knowledgeable and experienced broker
in areas such as order placement, market research and trade strategies.
Reliance on a broker can also help avoid
trading errors. Many who are new to the commodities markets usually start with a full-service account.
For questions about trading accounts,
please Talk to a commodities professional below and at right or
Ask a Broker.
You will need to fund a trading account with risk capital meaning money that can be lost without
it having any significantly adverse impact on your lifestyle. The option and spread-buying strategies discussed on this site
are debit trades meaning that you pay the full cost upfront to enter into the trade. You will also need cash to cover
brokerage commission and other trading fees.
Executing an Option Order
Your order to buy a commodity call or put option, whether placed verbally through a broker or directly through an online
trading platform, constitutes a bid for that option - the price at which someone is willing to buy the option. The ask
or offer is the price at which someone is willing to sell the option. The highest bid and lowest ask constitute the
current market for that option. There is usually a difference or spread between the bid and ask prices which becomes larger the
less liquid is the option market. For example, options of long maturity and/or that have a strike price far from the market
price of the underlying commodity can have a relatively wide bid-ask spread.
If you use a market order to buy an option, then your bid is automatically raised to the ask price. In other words, you
will pay the current ask price for that option. This price may be higher
than the last trade price or an exchange-determined settlement price meaning that you may end up paying more for the
option than you had anticipated. This is the
main characteristic of a market order: you get an immediate fill but have to pay whatever price is necessary for an immediate
fill.
In order to have some control over the fill price, many traders prefer to use
a limit order
instead of a market order. With a limit order, the limit price - which constitutes your bid - is the most that will be paid for the option.
If the limit price is below the current ask price for that option, then your order will remain open and unfilled. Should the ask
price drop to your bid - and remember that option prices naturally fluctuate during the day mostly in response to
movements in the price of the underlying commodity - then your order to buy will
likely get filled.
This is referred to as "working the bid" or "working the market".
The disadvantage of the limit order is that if the limit price is set too
far below the market, then the order may not get filled and the option will not be purchased. Consequently, you
could miss out on a profitable trade. These two factors - the urgency to buy the option and the price you are willing
to pay - need to be balanced. In most cases, you will probably set the
limit price close to the last trade price of the option or to the prior day's settlement price if trading at the start of
a new day. If you have a full-service trading account, then your broker can provide valuable assistance.
Executing an Option Spread Order
When executing an option spread, both the buy and sell need to be done simultaneously. To do each transaction individually
is referred to as "legging" into the spread and this introduces unnecessary risk both over the final cost of the spread and
the market exposure created if, for example, one side or leg gets executed but not the other.
Option spreads can be executed with a spread order that, if filled, simultaneously executes both legs of the spread, meaning the
buy transaction and the sell transaction. In some markets, you may be able to control the price of the option spread by
using a limit spread order. In this case, the limit price that you specify is only the difference in price between the two
component options and not the price of each option. As with a limit order for an option, a limit order to buy an option
spread fixes your bid price and you will work the market, hoping that the ask drops to your price. If not, the spread order
will not get filled.
Orders for option spreads are in general more difficult to execute than orders for individual options. Individuals
who open a broker-assisted trading account can and should rely on their broker for assistance.