Deciding to trade futures contracts or futures options is one of the first decisions new commodity traders make. Many existing commodity traders also waffle back and forth on this issue as to which is a better method for trading.
Futures and options both have their pros and cons. Experienced traders often use both futures and options, depending on the situation. Some traders like to focus one or the other.
It is best to fully understand the characteristics of each in order to decide how to trade commodities.
Trading Futures Contracts
Futures contracts are the purest vehicle to use for trading commodities. These contracts are more liquid than option contracts and you don’t have to worry about the constant options time decay in value that options experience.
Futures contracts move more quickly than options contracts, as options only move in correlation to the futures contract. That amount could be 50 percent for at the money options or maybe 10 percent for deep out of the money options.
For day trading purposes, futures contracts make much more sense. There is usually less slippage on futures than options. Futures contracts move quicker than options and they are easier to get in and out of.
Many professional traders like to use spread strategies, especially in the grain markets. It is much easier to trade calendar spreads (buy and sell front and distant month contracts against each other) and spreading different commodities like selling corn and buying wheat.
Many new commodity traders start with option contracts. The main attraction with options for many people is that you can’t lose more than your investment if you buy options. That is true, but if you only risk a small portion of your account on each trade, the chances of running a negative balance is slim.
Trading options can be a more conservative approach, especially if you use option spread strategies. Bull call spreads and bear put spreads can increase the odds of success if you buy for a longer term trade and the first leg of the spread is already in the money.
Futures options are a wasting asset. Technically, options lose value with every day that passes. The decay tends to increase as options get closer to expiration. It can be frustrating to be right on the direction of the trade, but your options still expire worthless because the market didn’t move far enough to offset the time decay.
Just as the time decay of options can work against you, it can also work for you if you use an option selling strategy. Some traders exclusively sell options to take advantage of the fact that a large percentage of options expire worthless. You have unlimited risk when you sell options, but the odds of winning on each trade are better than buying options.
Options don’t move as quickly as futures contracts, but some option traders like it that way. You can get stopped out of a futures trade very quickly with one wild swing. Your risk is limited on options, so you can ride out many of the wild swings in the futures prices.
As long as the market reaches your target in the required time, options can be a safer bet.
I typically like to trade futures contracts and I also use option selling strategies. I still buy options on occasion and sometimes I’ll do option spreads. You can almost always find an ideal option spread in any commodity market at any time. If I want less risk on a trade, I will typically sell an option instead of using a futures contract.
For example, if I thought the coffee market was too volatile and there might be too much risk buying a futures contract. The daily swings are $2,000 and I don’t want to get stopped out from normally daily fluctuations. In this case, I might sell a put near the money if I thought the market was going higher. My risk is more than cut in half with this strategy and as long as the market is above the strike price at expiration, I make 100 percent on the trade (minus commissions).
There are pros and cons to each side. Each trader should educate themselves on how to fully utilize futures contracts and options. From there, it is a matter of using the strategies that make sense for you.
Both futures and options are derivatives. Think of the world of commodities as a pyramid. At the very top of the structure is the physical raw material itself. All of the prices of other vehicles like futures, options and even ETF and ETN products are derived from the price action in the physical commodity. That is why futures and options are derivatives.
Futures have delivery or expiration dates where they must be closed or delivery must take place. Options also have expiration dates, on those dates the option, or the right to buy or sell the underlying future, lapses.
Long options are less risky than short options. When you buy an option all that is at risk is the premium paid for the call or put option. Options are price insurance – they insure a price level (called the strike price) for the buyer of the option. The price of the option is the premium. Premium is a term used in the insurance business, commodity option prices are premiums reinforcing the nature of the price insurance. However, when one sells an option they become the insurance company. The maximum profit for selling or granting an option is the premium received. An insurance company can never make more than the premiums paid by those buying the insurance.
Since commodities are volatile assets, option prices can be high. The price of an option is a function of the variance or volatility of the underlying market. The decision on whether to trade futures or options depends on one’s risk profile, time horizon and opinion on both the direction of market price and price volatility.