• Put & Call Options Explained

  • Today I'll go over put call options explained in detail. There are only two kinds of options, Puts & Calls. In the most simplistic form, you want to buy a Call option when you feel the price is going up and you want to buy a Put option when you think the market is going down. We are going to be bearish coffee in the following example so we would look at buying a Put.

    A simple way to remember Puts & Calls is that Put=Plummeting Prices and Calls=Climbing Prices.

    Strike prices in Coffee trade in increments, like 1.400, 1.375, and 1.350. (Strike prices are set by the exchanges and you are not able to pick your own strike price.) The first thing that I would do after deciding that I was bearish this market is to go back to the long term charts and find the next major support below the current price.

    As you can see on chart below the next major support on a weekly chart is about 1.19500.

  • Bearish Put Call Options Explained

    When drawing out support and resistance lines on my daily charts, I use red for resistance and blue for support lines. If the support is from a monthly chart, I use a line thickness of three, two if it’s from a weekly chart and one if it’s on the daily chart. Track-n-Trade makes this very easy for you to do. This way, I can glance at my daily chart and see exactly where monthly, weekly and daily support and resistance are. This makes the chart much more visual and easier to understand. It helps my charts “talk” to me. 

    Now, since I’m bearish my main focus is on the next level of major support at about 120.00. I will use this area as a profit target using a put option. 

    Also, I’m going to share with you something that will help you in all your trades in both futures and options and it’s a little known secret off the trading floors. It’s that many times support & resistance areas are option strike prices! Or, to put it another way, option strike prices often become support or resistance levels. 

                Now since we are bearish, we want to consider buying a put option but which one should we buy? The closer the strike price is to the current price of the futures market the more expensive it is. As an example if coffee is trading at 1.3825 then a put option with a strike price of 1.300 would be more than one with a strike price of 1.200 and a strike price of 1.100 would be cheaper than the 1.200 Strike Price. The closer the strike price is from the current market price the more expensive it is.

  • Put Call Risk Minimization

    I’m a firm believer that you MUST use proper risk controls when you trade or you won’t be around very long. One of the key mistakes new traders make is that they risk to much of their account on any one trade or have too much at risk in any one market (like the Grains, Metals, Meats, etc.)

    With a small account (and I think anything less than $10,000 is a small account) that you should not risk more than 5% ($500) on any one trade and the larger your account the less percentage you should risk. In other words, with a $100,000 account you might only want to risk 1% on a trade but with a $10,000 that’s almost impossible because you could only risk $100 (1%) and there are not many trades worth taking that only have a $100 risk. When figuring your risk, also include commissions and some slippage also.

    It’s probably a good time to mention that what you pay for an option is not what you have to risk on the trade; that’s completely different. What you pay for the option is your maximum risk. Let’s say that you have a $5,000 account and you only want to risk $250 (5%) but there is a great option that cost $500 which is 10% of your account. Well you can buy the $500 option and then offset it (get out of the trade) if the value drops to $250 which would be a $250 (5%) loss. So the option premium was 10% of your account but the risk you take is only half that or 5%. 

  • You don’t have to keep the option and let it expire worthless, you can offset your position anytime you want to. In this respect, it’s like a futures contract; you don’t have to keep a futures contract until it expires either.

    The first thing to decide is your exit strategy and the risk you want to take. Like I said, we are going to use the total premium cost as our risk in this example. So we could set exit targets several different ways. We could say that we are going to sell the option if we make 200% and it TRIPLES in value or we could say that we are going to let the market tell us when to sell it.

    Now hold on David, what do you mean it has to triple in value to make 200%? Don’t you mean doubles in value? Remember I’ve always talked about keeping your risk reward ratio at 2:1 or better when possible. Well you have to do the same thing in options. So if you paid $500 for an option, that money is gone forever, you don’t get back your premium whereas in trading futures, you put up a deposit (margin) and you get that back if you exit the trade with a profit. In options it doesn’t work that way. The premium you pay for the option is gone forever, you don’t get it back. 

    So if you paid $500 for the option and decide the entire option premium is what you are going to risk then how much do you need to make to have a 2:1 risk/reward ratio? That’s right; you need to make a $1,000 profit. So to make a $1,000 profit on an option that you paid $500 for, then the option must increase in value to $1,500. Why? Because you paid $500 for it and have to deduct what you paid from your profits. $1,000-$500 is $1,000 or a 2:1 return. If the option went up to $1,000 and you liquidated it, then you would only have a profit of $500 and your risk was $500 which means your risk/reward ratio was only 1:1. And yes, if you are thinking that your plan could have called for you to offset the option and get out of the trade if it dropped in value to $250 and sell the option if it went up to $750 which would give you a 2:1 Risk/Reward Ratio. If that was your plan BEFORE you got into the trade then you could take the profit when the option doubled in value. There are many ways to skin a cat. (Sorry cat lovers) 

    Okay, I’ll quit rambling and get back to the example again. Since the next major support on this chart is 1.2295, I’m going to look for support somewhere around 1.2225. Why 1.2225? Because 1.2225 is an option strike price. Remember that many times option strike prices will become support or resistance levels. REMEMBER THIS!

    Many contracts have multiple days to expiration. Coffee as of today on the Dec. 2015 contact has opens that expire in 24, 54 and 87 days. Of course an option that expires in 87 days is going to cost more than an option that expires in 22 days. The reason is that with an option that expires in 22 days you have a much shorter time frame for price to hit your target than you would if you bought an option that expires in 87 days so it cost less. To people who sell options, time is money because the more time “they give you” the more risk they take and the more money they want for that option. Also the last 30 days of an options life has the most time decay (loses time value (money) faster every day). More about this in another article.

    In Track’n Trade Live it’s very easy not only to find the current price for an option but also a ton of additional information on each option strike price.

    Look at the three examples below and you can see that the 1.200 Put is cheaper if it has only 24 days until expiration and more expensive if it has 87 days till expiration. Remember, time cost money.

  • I would not buy the option with only 22 days left on it because price has to come a long way down to hit the 1.200 strike price so it is probably going to expire worthless and the entire premium you paid will be lost. It would be a much better choice to buy the 1.200 Put that expires in 87 days. If you can only risk say $500 on the trade, you can always sell the option if it loses $500 in value. This way you don’t have to risk the entire $768.50 in premium you paid.

    Now if the price starts to come down how much will the Put option increase in value? That’s a good question and it has to do with the Delta of the option. Delta is a fancy term that tells you how much an option will increase or decrease in value compared to the underlining futures contract. Track’n Trade does a wonderful job at telling you what the Delta of the option is.

    Look at the image below and you can see in the last column under Delta it tells you that it’s -0.21. Puts are always shown with a “-“before the number and Call are always a positive number. This just tells you that the Put option will increase or decrease in value 21% of what the futures market does. So if Coffee drops $1,000 in price the Put will increase $210 in value. This changes as the Delta changes and it changes a little each day depending on which way price goes.

  • With Put Call Options explained, you can now read and understand how they work.