Introduction to Options

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Purchasing ETF options is one way to gain leveraged exposure to the broad equity market, but savvy traders also understand that options on futures are another way to gain similar exposure to the same market.

Trader expectations and needs;

- Kraig and Caitlyn both expect the S&P 500 to make positive gains.
- Both would like to limit their downside risk.
- Caitlyn wants the ability to trade around the clock.
- Both traders could meet their needs is by using options.
- Each trader has a brokerage account worth $20,000.
- Commit no more than $1,500 for this trade.

We will assume the market for the S&P 500 is currently at 2,300. Kraig considers buying an SEC regulated SPY option. Caitlyn is looking at a CFTC-regulated E-mini S&P 500 option, product symbol ES. Caitlyn knows about SPY options but she wants the ability to trade nearly 24 hours a day. After all, it is a global economy and market events can impact prices any time of the day.

With the S&P500 index at roughly 2,300, the SPY ETF is at 230. Each SPY option has a 100 share multiplier, so the notional value for each SPY option at 230 is;

100 X $230 = $23,000.

Kraig is looking at the Feb 230 call option on SPY, priced at $2.50. If he buys five options, it will cost him;

5 options X $2.50 X 100 = $1,250

The notional value for five SPYs;

5 X $23,000 = $115,000

With the S&P500 index at roughly 2,300, the ES future is roughly 2,295

*(Equity index futures tend to trade at a slightly different price than the underlying index due to cost of carry)*

Caitlyn is looking at the Feb ES options strike at 2,295. ES options settle into one ES future which has a $50 multiplier. So the notional value for each ES option is;

$50 (multiplier) X 2300 (index) = $115,000.

Assuming the equivalent Feb ES 2,295 call option is trading at $25. If Caitlyn buys one 2,295 call option, she spends;

$25 X 50 (multiplier) = $1,250

Both traders submit their orders and which are executed immediately.

- Caitlyn had $20,000 in her futures account at her FCM. Her account will now show; $18,750.00 ($20,000 – $1,250) and long one ES Feb 2,295 call option.
- Kraig’s account will show a similar balance of $18,750.00 ($20,000 – $1,250) and he is long five SPY Feb 230 call options.

In February when contracts expire, the S&P500 Index has risen to 2,400.

The futures are now trading at 2395 and the SPY is 240. At expiration Caitlyn’s option is “in the money” and exercised at 2295.

Caitlyn now owns one ES March future contract for which she paid 2295. The March futures is currently priced at 2395. That is a 100-point gain. If you multiply that by the $50 multiplier you get $5,000.

Add that to her existing account balance and you get a new account balance of $23,750. And she is still long one ES March future. Because Caitlyn now has a futures position, she will be required to post margin. Assume the E-mini S&P500 futures requires initial margin of $5,280 per contract. The FCM will see that Caitlyn’s account has more than enough to cover the required margin. This leaves her with $18,470 excess capital.

Now look at Kraig’s position at expiration. With the SPY trading at 240, Kraig’s option is in the money and is exercised. He now must pay for 500 shares of SPY at 230 per share. Which costs $115,000.

Assuming his account is subject to 50% margin his account must have half of $115,000 or $57,500. His current account balance is $18,750, so he needs to borrow an additional $38,750.

Would you rather prepare to manage your next move with your excess capital or have to find additional funds to keep this trade alive?

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