Influence of Pricing on the Option for Equity Traders

Influence of Pricing of Options

A trader who is already familiar with how options are traded will find that the pricing of options on futures is guided by the same principles. Using factors like time, volatility and the ability to trade options in, at or out of the money gives a trader many choices and flexibility to trade. Options on futures are just like options on equities as their price is based on the price of an underlying asset; thus, the influence of option expiry will affect the trade.

Specifically, the influence of theta, or time decay and premium or intrinsic value and the flexibility to trade options at the money, out of the money and in the money are relevant and will be important for both options in equities and futures.

This course will look at how some characteristics of how an option is priced will impact your decision to trade options on futures.

Influence of Theta or Time Decay

All options traders will need to know how to leverage time to their advantage when making trades. This means having awareness of the influence of time decay on options. Just like an option in the equity market, an option on a futures contract will expire at a given time. The influence of time, or theta, decay will impact both an equity and futures option trades in the same way. Each options trade will be influenced by how much time the underlying will take to move and the value of the underlying at that given time. As an options trader, you might analyze the market and set up your trade based on factors including the amount of time you think it will take the anticipated move in the underlying to take place before the option expires. 

Example - Directional

An equity options trader could analyze Apple (AAPL) and determine they want to trade a bullish assumption because they believe the stock price will increase soon. This trader might purchase a call with an option that will expire on a specific date, such as  two weeks, to take advantage of their anticipated move. This AAPL trader will want to see their expected move by the time or before the option reaches expiry.

The same is true for an options trader who analyses E-mini S&P 500 futures (ES) and determines they want to trade with a bullish assumption and anticipates the move will happen soon. The ES trader could choose to purchase a call option that expires in two weeks as well. The ES trader will want to see their expected move by the time or before the option reaches expiry.

As an added advantage, the options on futures trader can actually choose between a Monday, Wednesday or Friday expiry for some markets, giving them even more choices to trade. So, for the options on futures trader who is buying a call in ES, they can fine tune their trade with even more flexibility of time.

Example - Spread

Let's say it's Tuesday, and a trader wants to take advantage of the rapid time decay in the last few days of expiry. The trader has a bullish to sideways assumption for the market over the next few days, so they could sell an out of the money put credit spread to take advantage of the time decay. If the ES is trading at 2265, they could sell a 2235 put and buy a 2230 put that expired at the end of the week for 0.30 points. If the market moved sideways or up, the trader would keep the entire credit received if the ES closed above 2235 at expiry.

Influence of Premium and Intrinsic Value

Another consideration for all options traders is premium and intrinsic value. With all options, the intrinsic value and premium will change the price of the option, thus influencing a trader’s set up and ultimately the profit and loss of a trade.

Many trade set ups will be based on where to purchase the option in relation to the underlying price, taking into consideration the amount of value of the option. Trade set ups used to take advantage of premium in equity options in a stock like GOOGL, for example, will also be applicable in an options on futures market like E-mini NASDAQ (NQ). The equity options trader and the options on futures trader will consider the risks of buying or selling an option by weighing many factors including intrinsic value and the amount of premium embedded into the price of the option.

Just like equity options, a market with high and decreasing implied volatility will favor an options seller, while an options buyer will favor low and increasing implied volatility. Since an options trader will most likely be familiar with selling to take advantage of premium decay and/or buying to take advantage of larger moves in the underlying, the options trader can apply this knowledge in the same way in the options on futures market. 

Example - Credit Spread

A Corn contract might have high implied volatility and a trader decides to trade by selling a spread. If they believe that Corn (ZC) might increase in value over the next few weeks, they could sell a put credit spread that expires in three weeks. If Corn is trading at 358, they could sell the 340 put and buy the 335 put creating a credit of 7/16 points in Corn. The trader would be profitable if Corn closes above 340 at the end of the month.

Flexibility to Trade Options At-the-Money, Out-of-the-Money and In-the-Money

Options on futures allow you the ability to choose to trade at, in, or out-of-the-money, all of which will vary the cost of the option and its risk/reward profile (just like an equity option). Trades can be placed at-the-money and benefit from trading at levels where price is currently hovering, or trade out-of-the-money to take advantage of collecting premium, or a big move in the underlying. The flexibility of trading in-or out-of-the-money allows the trader to adjust the risk/reward profile they prefer.

Example - Directional

A trader who thinks that Gold futures (GC) will sky rocket to new highs could buy an out-of-the-money call. If GC is trading at 1184, a trader might buy a 1280 call for around $5.50; since all the cost of the option is premium, GC must have a large move by expiry for this option to pay off. If the trader wants to better replicate the performance of the underlying futures contract, they can pay more and buy an in-the-money call. They could buy an 1170 call with the same expiry, but this might cost around $38.

As you can see, there is a balancing act between probability of the option being in-the-money at expiration and the cost to purchase the option.

Summary

Just like equity options, trades in options on futures can be placed at different levels providing flexible participation in the market. If you understand equity options pricing information, then you can put that same knowledge to use when trading options on futures.