Trading future and option
The potential losses when buying calls and buying puts are limited to the premium paid, whereas the upside is almost unlimited when buying calls and puts. A common problem among futures traders is that they do not use stop loss orders, use mental stops that are not executed with discipline, or continuously widen their stop loss order when the trade goes against them.
When buying options, the risk is predetermined and it is limited to the premium paid. If you have bought a call or a put, volatility only has a limited impact and, especially important, your option will remain valid even if the price moves against you substantially; the greatest limiting factor in options trading is time. This advantage is a consequence of the previous point. Often, traders are better at picking the broad market direction, but their timing and their stop loss placement is off, which then results in unprofitable trades although they can see that price eventually made it to their initial take profit.
When buying options, the entry timing of trades has a smaller impact and the influence of stop loss orders is not present at all, but knowing the broad direction is more important. Revenge and over-trading are among the most commonly made emotionally caused trading mistakes and they are the result of inferior coping mechanisms when it comes to realizing losses.
Traders often personalize losses and after a loss still believe that their trade idea is right, which then causes them to open another trade, often without valid entry criteria and purely based on impulsive reactions. When buying options, the impacts of stop loss orders are removed because the only thing that determines whether you lose or make money, is the price of the underlying asset when the option expires.
During an options trade, you do not get direct negative feedback about your position which can potentially remove the impacts of emotionally caused trading decisions to some degree. Due to the unique characteristics of options and the way their payoff is structured, different types of option contracts can be combined to capitalize on very specific market behavior.
Whereas a futures trader is limited to either trade with buy or sell orders, an options trader can choose from a variety of scenarios and, therefore, tailor his trading methodology around his personal needs, his investing perspective and the trading tools used. If Corn were to have a major spike in price and shot up to For example, if you were to buy a call option on Corn with a strike price of So, buying a Corn call option with a But if Corn were to have a dramatic and quick spike in price, and it jumped up to Nonetheless, I hope this little diddy on call options explained has at least begun to bring some clarity to this detailed area of investing.
If you understand the effect that volatility has on the options market, you will understand how sometimes extraordinary profits can be pulled from trading commodity options with very little relative investment.
When you trade options, you are basically trading volatility, nothing more, nothing less. Remember the option is only going to be as stable as the futures contract that the option represents. Volatility is basically reflected in the sharp rises and drops in option premiums, and the degree of fluctuation that those premiums experience. If you use it right, volatility can be your best friend.
Once you understand a little about market psychology, you can truly exploit volatility to create some serious profits in a relatively short period of time. Before I get sidetracked, let me mention the fact that there are two types of volatility in commodity options trading and really all options trading for that matter: In other words, how stable or unstable have market prices been throughout history?
The basic reason why it is important to understand volatility is because it will tell you what your best plan of action is, as far as what type of position to take in the markets. In the realm of commodity options trading , you have to be prepared to face the uncertainties and volatility that the futures markets can throw at you. You have to keep in mind that options is simply a game of educated guesses.
It is vital for you to make that distinction before even beginning to enter a trade. The options markets are inherently speculative. The whole drama of it is the big question mark about what the markets may or may not do.
This is where you get volatility skews and parity in puts and calls. This is why option writers pad their premiums the farther out in months the options go, because they realize that the farther the timeline extends, the more probability there is for uncontrollable events to affect market prices.
When this major drop in value happens, if you are wise, you will exit by offsetting your position instead of allowing your option to expire worthless.