One attractive feature of trading futures is the availability of leverage. Leverage, in the financial sense, is the use of a relatively small amount of collateral (pledged assets) in order to control a proportionally large amount of a security - in this case a futures contract. One way to achieve leverage when trading is to use a margin account.
In order to leverage your trading capacity, you open a margin account. The margin is "the amount of equity contributed by a customer as a percentage of the current market value of the securities held in a margin account." Equity can be in the form of cash or by pledging other securities, such as bonds. Margin requirements are minimum levels that must be met. These limits are set by exchanges – and managed by brokers – in order to reduce credit risk (the computed value of a trader not fulfilling his obligations). Margins are required from both your futures commission merchant and you, and vary between exchanges.
When a position is closed the broker receives the proceeds and deducts the cost of providing the margin to the account holder. The amount deducted is based upon the margin rate the broker charges. The margin rate is the interest rate applied to your account while margin trades are in effect. If the trade results in a loss, the margin cost must still be paid from the proceeds. Because futures exchanges require open positions to be marked to the account daily, account holders must constantly be aware of the margin requirements. Keep in mind that if equity falls below margin levels, you will receive a margin call.
An example of a margin call:
Trader buys $10,000 in Treasury Bill contracts using a $5,000 initial margin (50% equity, 50% margin)
Contracts' value drops to $6,000 (result = Equity/$1,000 Margin/$5,000)
Broker's maintenance margin is 30% (30% of $6,000 = $1,800)
Margin call for $800 would be required ($800 + $1,000 = $1,800)
In this example, the account holder must deposit $800 cash, sell other securities that return $800 or close enough of the open position to increase the equity to $1,800. Keep in mind that, any security sales will result in the margin rate also being deducted. It is important to note that the broker has the right to liquidate (close) your position without consulting you, even if you ignore the margin call.
There is a distinction between an initial margin call and a maintenance margin call. Securities such as warehouse receipts or government-issued assets can be pledged for initial margin requirements, whereas maintenance margin calls must be met with either cash deposits or exiting the position. Maintenance margins are based upon market action and therefore require immediate cash transactions in order to return the account to adequate equity levels.
Options are another form of leverage, which involve additional risks and rewards. An option is a contractual agreement that gives the option buyer the right, but not the obligation, to purchase or sell a futures contract. It can provide protection against a price decline on a commodity or a bet on the movement of a market index or similar investment.
Options are used by hedgers as an "insurance" policy on their assets, as well as by speculators who wish to commit a smaller amount of money towards their expectations. The seller (otherwise known as the writer) extends the offer to the buyer (called the holder) in exchange for a premium – the price of the option. The difference between the two sides is that the holder is not obligated to fulfill his commitment on the contract, but the writer must make good on the obligation if the holder chooses to exercise his right.
The holder of the option can close his option interest in two ways: 1) exercise the option by purchasing or selling the underlying contract to the writer or 2) offset his position by selling a long position or buying a short position on the same option contract. In the US, the holder can exercise his right at any time prior to the option's expiration date. Options can be exercised by either physical delivery of the futures contract or by cash settlement, in which the value of the underlying contract is credited to the account holder minus the original specified futures contract price.
PUTS –A put gives the holder the right to sell a contract at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.
CALLS – A call gives the holder the right to buy a contract at a certain price within a specific period of time. Put another way, calls offer the ability to establish a long position on a contract. Buyers of calls hope the contract price rises before the option expires.
Example: On the CBOT, the March Oats futures contract trades at $2.00 per bushel. There are March call options with strike prices of $1.95, $2.00, $2.15 and $2.18. The option pricing looks like this:
$1.95 strike price = $.30/bu
$2.00 strike price = $.10/bu
$2.15 strike price = $.05/bu
$2.18 strike price = $.02/bu
This means that it will cost the option holder $.30/bu ($1,500) to buy the March 1.95 strike call option. If she chooses to exercise the option, the actual cost per bushel will be $2.25/bu.
When the current (spot) price for the underlying contract is lower than the strike price of a put option or higher than a call option, the option has intrinsic value. The premium for the option rises and falls (just like the underlying contract) based upon factors such as the intrinsic value, market volatility and the time until expiration (called the time value). Option premiums tend to decline as the expiration date draws nearer.
The risk level for buying an option changes as the spot price moves, and that level is reflected in the premium. Risk is greater as the option moves more out-of-the-money and lesser as it becomes more in-the-money. There are complicated formulas that professional traders use to determine the timing of entering and exiting an options position that reach far beyond the scope of this article.
|How Options Leverage Works|
March Oats at $2.00/bu ($10,000/contract) and March $2.00 strike call option at $.10 ($500/ contract). With $10,000 a trader can purchase one March futures contract or 20 call options. With the same amount of money, you can control 20 times more bushels buying the option.
Leverage expands a trader's gains and losses because small movements in the underlying contract are multiplied by the number of units you are controlling. The downside is that, as the option expiration gets closer, the risk of loss becomes greater because the time value decreases rapidly, which puts the initial investment completely at risk. In addition, option prices usually don't move equally in relation to the futures contract, thus requiring greater relative movement in the futures contract in order to realize a gain on the option contracts.
|Buying vs. Selling Options|
Traders employ an option basis – a formula that calculates the value difference between a put and a call – to determine the appropriate spot and strike prices to enter or exit a position. This includes the commission costs, capital gains taxes, etc. Another formula, called the delta, indicates how the option price will move relative to the futures price. Call options have a delta between 0 and 1 and put options have a delta between 0 and -1. If an option has a delta of 1 or -1, that means the option price moves $1.00 for every $1.00 movement in the underlying contract. For example, the price of a May Wheat call option with a delta of 0.50 will increase $.50 for every $1.00 rise in the contract price.