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Have you ever heard someone say "call" or "put" and just be totally confused? How about the terms "in-the-money" or "out-of-the-money"? Have you ever wondered what you might be missing? In this article we will look at options trading, go over the basics, and show you that with a little time you too can become familiar with the world of futures options trading.

First, let's take a look at what an option is. Basically, an option is the right to do something; In this case, the right to buy or sell something at a specific price. The right to buy something at a specific price is called a "Call". The right to sell something at a specific price is called a "Put". Now here's what makes options trading so fascinating -- you can actually buy and sell this right. If you buy the option you are the option buyer. If you sell the option you are the option writer. With these two features, various combinations of buying and writing puts and calls can now be used to establish both "long" and "short" positions in the market. They can also be used to set up strategies that will be profitable regardless of which way the market is moving, just so long as the market moves a certain amount. It should also be emphasized that while some strategies may be profitable, there is always substantial risk in trading options as well. The other term we need to look at is "premium". This is the amount of money paid for the option. This is a cash transfer from the buyer to the seller. There are three components to premium -- intrinsic value, time, and volatility. Intrinsic value is the difference between the strike price and the current market price if the option is exercised. If exercising the option would result in a losing trade, the intrinsic value is zero. The time component is tied directly to the length of time remaining on the option until it expires. It always has a negative effect on the value of the option. If and the buyer doesn't exercise his right, the option expires worthless. The other component, volatility, is the rate at which the price of the underlying commodity is changing. If the price is changing at a higher rate, then it stands to reason that it is more likely that the option will become profitable.

Options buying is also usually a much cheaper way to establish a long position especially in the futures markets since the margin requirements for many futures contracts are much larger than the cost of the related options. Take crude oil futures for example. The overnight margin requirements to hold a position in crude oil is approximately $10,000. If on the other hand, we just wanted to buy options on crude oil, our out of pocket costs can be dramatically reduced. Here is a brief example of what can happen. Let's take today's pricing for crude oil. Crude closed the day at $127.70 per barrel. Let's say that we think crude oil is going to go back above $130 per barrel. If we do not have the $10,000 required to buy crude oil futures directly we can still go long the market by buying a call option on crude for much less. For example, a crude oil call option for $130/barrel just settled at a value of $3,500. We will now look at some basic plays and see what scenarios may make the trade profitable.

The most easily understood option trade is the long call. What happens in this case is that a trader buys the right to purchase an item at a specific price thinking that the price of that item is going to go up. If the price of the commodity goes above his specified price (also known as the "strike" price) then the options is considered to be "in-the-money". Essentially, the owner of the call has the right to purchase the item at his specified price regardless of how high the price is. The buyer can then immediately sell the item at the current market price for a profit. For example, let's say we think the price of gold is going back above $910/oz. We buy a gold call with a strike price of $910. After some time passes, the price of gold goes to $930. With the call that we own, we now have the right to buy gold at $910 even with the market currently trading at $930. Given the current contract specifications for full-size gold futures and before deducting the price paid for the option, that trade grossed $2000!

Another basic trade in options is the long put. The owner of the put has the right to sell an item at a specific price thinking that the price of that item is going to go down. All the logic used on the long call strategy is now applied in reverse to the put. The owner of the put has the right to sell the item at his specific price regardless of where the market is currently trading. All the owner of the put has to do is go out and purchase the item at the lower market price then turn around and sell at his protected price, netting out a profit.

Up until now, we have been looking at the purchase of these options. As one can see, they can be a less risky alternative to trading futures directly since the buyer can only lose the premium paid plus commissions. The drawback is that the investor has to wait until prices change to point that the option can be exercised for profits. Conversely, the option writer gets to receive the immediate cash inflow from the option he sold. However, this strategy is much more risky because the seller is obligated to perform whatever right he sold to the buyer. We will now look at a couple of option writing situations.

First, consider writing a call option. In this scenario, the option writer sold the right to buy. What did this do? Basically, the call writer now has the obligation to sell. The risk on this trade is unlimited because there is no limit as to how high the price can go and the writer of the call is obligated to sell at the strike price. Writing calls is considered a bearish trade since the writer of the call wants prices to fall. Now, consider writing a put option. What did this do? The option writer sold the right to sell. Because of this, the put writer now has the obligation to buy. The risk on this trade is also significant because of the obligation given to the writer. The risk to writing puts is theoretically less than writing calls only in that the price of an underlying item cannot go below zero. Writers of calls and puts are subject to margin calls as well since there is potential for them to be assigned a full long or short position if the option they sold gets exercised. In spite of all of this, option writing is considered more lucrative because of the cash inflow from the receipt of premium. Further, anecdotal evidence does suggest that options expire more often than not giving more incentive to the option writer.

I hope you enjoyed this brief discussion on options trading. The trades mentioned above are just the tip of the iceberg as to the possible strategies available to the open-minded investor. In future articles we will look at more complex option strategies like "straddles", "Butterflies", and "condors" and how to use them to your advantage. If you can't wait and want to know more right away, contact our firm. We are here to help. Good trading!

Michael Rovira is an account executive at Trade Center, LLC. He has a degree from the University of California, Santa Barbara in the field of Business Economics and Accounting. Michael has been with Trade Center since 2007 and has over 5 years experience in finance and investment banking.