Leverj Leveraged Futures Options Trading

Leverj leveraged futures options trading

Futures vs.

Leverj leveraged futures options trading

equity options

The fundamental characteristics and mechanics of options in all arenas are identical.

Both options on stock and options on futures are derivatives (value is derived from the value of something else). In both trading venues, there are two types of options (calls and puts), both have strike prices, expiration dates and mathematically the payoff diagram will be identical, but there are two very important differences: The nature of the underlying vehicle and the logistics of market execution.

There are also some peripheral differences that you should be aware of such as tax treatment, regulation and margining.

Leverage

Options inherently provide leverage to the buyer; however, options on futures are derivatives of an already levered vehicle.

Leverj leveraged futures options trading

This is in contrast to stocks which do not expose investors to leverage (with the exception of those trading on stock account margin and certain exchange-traded funds).

As a result, any explosion in volatility could provide greater risk and reward to a futures option trader than would be possible via a stock option.

For example, a typical stock option has the potential to control 100 shares of stock should the option come into-the-money (ITM).

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If a share price is trading at $100, which is relatively high, the option has the potential to mimic the profit potential of holding approximately $10,000 of the underlying equity security. Keep in mind, out-of-the-money (OTM) options, or those whose strike price is out of reach of the underlying security price, do not see price changes equivalent to being long the underlying shares. Instead, OTM options expose traders to relatively mitigated risk and reward.

Most commodity options provide speculators with risk exposure far exceeding that of a typical stock option.

Each commodity has a different point multiplier and contract value but to provide perspective on the difference in leverage between the two trading arenas, let’s take a look at a specific example. 

The value of an ITM corn option would oscillate similarly to the underlying futures contract, which represents the future delivery of 5,000 bushels of corn.  In June, corn was trading near $4.30 per bushel; so an ITM option accumulated profits and losses based on $21,500 of the underlying commodity.

Now that is leverage.

Futures Options

 

And corn is one of the least expensive futures markets. An at-the-money (ATM) crude oil option represents about $50,000 worth of WTI crude oil.

An ATM 30-year bond option represents the future delivery of a $100,000 of Treasury bond. For example, an E-mini S&P 500 option would represent about $100,000 in the underlying securities, or if you went with the full-size S&P 500 at $250 a point, it would be $500,000.  

However, very few traders participate in the big S&P anymore.

Margin Deposit Requirements

These are clearly higher risk/higher reward, ventures than stock options provide.

Not surprisingly, commodity options tend to be a little more expensive compared to similarly positioned stock options. Therefore, long option plays in the futures markets may be a little more challenging, but the winners have a potential to be relatively large.

Expiration 

Both stock and futures options have an expiration date.

Leverj leveraged futures options trading

Unlike a stock, which has no finite life span, a futures contract does. Depending on the futures market traded, the contract may expire on the same date as the option, or it may be at a relatively proximate, but distant date. Consequently, there is a finite time span on option strategies in the futures markets. For instance, a stock trader could sell puts with the willingness to accept delivery of underlying stock should it become ITM and holding indefinitely until prices swing favorably.

Because of futures expiration, commodity traders don’t have the same luxury of turning a trade-gone-wrong into a long-term investment; or at least not as conveniently as a stock option trader could.

A futures trader would need to continually roll over the position as the futures contracts expired, all the while suffering from contango.

Contango

Commodities have a carrying charge, or cost to carry, which is the cost of storing the commodity until it is to be sold.

Such costs include warehousing, insurance and the potential interest lost on the money tied up in the physical commodity. Because of these costs, it is reasonable to expect that a futures contract with a distant delivery month will be higher than that of a nearby delivery month.

This scenario is often referred to as contango.

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For example, if July corn is valued at $4.25, September corn might be at $4.32. The gap represents the cost to carry the inventory to the September expiration date.

Contango is an important and unique aspect of commodity options trading because it complicates the strategy of purchasing long-dated options.

Traders wishing to buy an option expiring a year from now will probably have to pay the contango. This means an ATM option already incorporates a far higher price for the commodity than the current going rate. A crude trader might find the contango between the front month futures contract and a contract expiring a year from now to be $4.

Fundamentally, the price of oil would have to increase by $4 for that option to be ATM a year from now. Even more detrimental to the strategy, the option must be ITM enough to recoup the premium paid to purchase the option.

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An ATM crude oil option with 12 months to expiration typically runs $7 to $8 meaning the price of crude would have to increase at least $11 ($4 contango + $7 premium paid) just to break even.

This is a nearly impossible obstacle to overcome and prevents most traders from attempting to buy and hold commodity options in the long-run. Stock option traders, on the other hand, can conveniently do so using Long-Term-Equity-Anticipation Securities (LEAPS). 

Dividends

This is a “no-brainer,” but it seems to be overlooked.

Leverj leveraged futures options trading

Unlike stocks, commodities pay no dividends. The only cash flow that occurs for a commodity trader is upon exit of the trade. 

Nature of market and price movement

The stock market tends to gain in value over time.

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Sure, there will be ups and downs, but the overall direction has always been higher in the end (see “Buy and keep on holding,” right)

Commodity prices, on the other hand, tend to trade in price envelopes (see “Range bound,” right)
In the case of agricultural commodities, supply and demand work together to find an equilibrium price, there will be long-term price swings toward the upper range of the envelope, and then fall back toward the lower end.

A cycle such as this may take several months, or even years, to develop; however, ignoring inflation the price action has always been sideways in the long term. 
Standardized point value

The most difficult aspect of trading options on futures is becoming familiar with how each contract is quoted. Unlike stock and stock option prices, which are standardized, each futures contract has a differing multiplier, contract size, and format.

Five Advantages of Futures Over Options

The discrepancies range from how premium is calculated, to how strike prices are displayed. This can be confusing for those in the industry, let alone a beginner. 

Differences in options markets

There are several thousands of stock options listed on the various options exchanges as well as equity indexes, but there are far fewer options on futures, less than 100 with enough liquidity to be efficiently traded. 

Liquidity

The liquidity in the options on futures markets can be spotty.

Leverj leveraged futures options trading

It is important to know which markets have enough participants to actively trade. A quick and easy way to determine if a market is suitable to trade is to look at the bid/ask spreads displayed on an option chain. If the spread represents more than $50 to $100, it probably isn’t worth the effort or risk to trade. 

Difference in tax treatment

The tax code can be complicated, especially when it comes to paying taxes on investment income.

We are going to highlight some of the key differences, but you should consult with a tax professional for details. 

Long-term vs.

Short-term: Realized gains and losses for security traders are categorized as short-term capital gains unless they are held for longer than 12 months. This is important because short-term gains are taxed at a higher rate than long-term gains.

Futures traders are allowed to blend their gains between the categories of long-term (60%) and short-term (40%). Thus, assuming that you traded profitably, you would be subject to a lower tax liability as a commodity option trader than a stock option trader on positions held for less than a year. 

Reporting Tax: To add salt to the wound, stock traders must report a detailed trade-by-trade account of the activity, for those that are active this could be cumbersome, time-consuming, and error prone.

Futures traders enjoy the simplicity of reporting a lump sum profit or loss on their tax return. 

Difference in regulators

The equity markets, and thus equity options are regulated by the Securities Exchange Commission (SEC), along with the Financial Industry Regulatory Authority (Finra).

Introduction to Derivatives

Finra is a self-regulatory body responsible for regulation with oversight of the SEC. Both have a relatively tight hold on the industry and work diligently to assure that proper protocol is being exercised by market participants. 
On a similar note, stock traders enjoy the luxury of FDIC and SIPC insurance on their cash and security holdings.

Commodity traders aren’t afforded these protections but they do benefit from customer segregated funds, discussed next.

All domestic futures exchanges are regulated by the Commodity Futures Trading Commission (CFTC), along with the self-regulatory arm of the industry, National Futures Association (NFA). Like the SEC and equities, these two agencies work together to assure proper conduct in the futures industry.

However, there is one key difference. The CFTC requires that Futures Commission Merchants (FCM) hold customer funds in an account that is segregated from their own. In other words, a futures brokerage firm is not allowed to co-mingle customer funds with their own. This is a critical distinction because it infers a brokerage firm failure won’t have a negative financial impact on its clients; unless, of course, they aren’t following rules and regulations as was the case in the meltdowns of PFGBEST and MF Global. 

Commission charges

It is commodity industry standard to charge option traders upfront for their option trades on a per-contract basis.

This means when a trade is executed, the client is charged the full commission but pays nothing when the trade is offset.

Option strategy hedge excess movement

Stock brokers offering commodities on the side tend to charge their option traders half in and half out. This means they pay half the commission upfront, and the other half when they exit.  In other words, they charge commission for futures and options on futures in the same manner. For those that hold options to expiration, most likely until they are worthless, there might be a small advantage in executing the trade with a stock broker offering commodity options as a side product as opposed to a traditional commodity broker who charges options upfront.

Nevertheless, there are arguably more disadvantages to doing so.

Portfolio margining

Perhaps the most significant difference between trading options on stock and options on futures is the way they are margined. A stock trader wishing to have access to portfolio margining, a margin system in which all positions in the trading account are considered to determine a net risk and an appropriate margin charge, must apply for it with his broker and is generally expected to have at least $100,000 in the trading account.

A futures trader, on the other hand, is granted a portfolio margining system known as Standard Portfolio Analysis of Risk (SPAN) regardless of account size.

Whether a commodity trader opens an account with a few thousand dollars or a few hundred thousand dollars, his positions will be levied margin based on the portfolio risk, not the individual risk of his positions. This is important because a trader who is short a call option and a put option in the same market, cannot lose money on both sides of the trade.

How Much Leverage Is Involved with Commodity Futures?

Without the benefit of portfolio margining, the trader would be charged margin for both positions, but compliments of SPAN, the client would essentially only be charged a margin requirement for either the call or the put, whichever is deemed to hold the most risk, but not both. In short, commodity option traders generally face lighter margin requirements and easier access to leverage than do stock traders. 

Cash to accept delivery

In addition to relatively higher margin burdens for the average speculator, stock traders are often required by their broker to have the cash on hand to purchase the underlying stock should the short option be exercised.

For higher priced stocks, this might be significant. For example, a trader short the standard 100 lot of Apple, might be required to hold $9,600 in reserve (assuming the price of the stock is at $96 per share) to purchase the shares if the short put is exercised. 

In contrast, a commodity trader isn’t necessarily expected to have the cash on hand to take delivery of the underlying commodity to initiate a trade.

Although if the position moves adversely they might eventually see their margin increase to levels nearing that of the underlying futures contract. Nevertheless, commodities themselves are leveraged so the cash outlay required to take delivery of them, should an option be exercised, is much lower than the true value of the contract.

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For example, a trader who shorts a $42 put option in crude oil expiring in 60 days while the futures price is hovering near $52 might be charged $850 in margin upon entry.

Should the option become ITM and be exercised, the trader would be required to hold the futures margin of $3,685, which is the equivalent of holding $42,000 worth of crude oil.

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Obviously, the commodity option trader is subject to favorable margins, lower potential cash outlays, and leverage. What should also be obvious, is that these differences come with higher levels of risk to speculators.

Know your options

While options on futures and equities share many common traits, there are key differences between the two that every trader must know before expanding their trading horizon.

Although a call and a put have the same general function, it is foolish to assume that differences in the underlying asset are irrelevant. Additionally, being familiar with the differences in logistics and market characteristics are necessary; especially for stock traders looking to migrate into the futures markets. 

When it comes to stock options relative to futures options, one isn’t necessarily better than the other, they are simply different.

Most importantly, they should be approached and traded according to these differences and the recognition that option trading, like any investing, involves risk.

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