Reflections of a Trader in the World of Options – A Journey Through Time and Trading
Options are financial instruments that give the purchaser the right to buy or to sell a specific commodity or stock at a specified price for an identified time frame. A call is the right to buy, and a put is the right to sell the underlying stock or commodity. The specified price for the option is called the strike price.
So let’s see how this might work. Brazil is the biggest competitor of the US in the huge global soy bean market. If an investor or speculator thinks that the price of soy beans is going to go up because the dollar has become very cheap compared to the real, the Brazilian currency, and the users are going to first buy the US soy beans, then he will buy a soy bean call. It is now December and the price of the January soy bean futures contract is $10.60 a bushel, while the May contract is selling for $10.80 per bushel. A May call with the strike price of $11.00 is currently selling for .40 cents per bushel. The contract is for 5000 bushels, times the cost of .40 cents equals $2000 per contract. This gives the speculator the right to call or own 1 contract (5000 bushels) of soy beans until expiration of the contract in late April.
Now we get to play what if. What if the speculator got it right? It rained extensively in Brazil, delaying the harvest. This forced more export soy demand to the US, and the US price went up. Then the port workers went on strike in Brazil and the boats could not be loaded. Brazilian farmers did not like the low price so they refused to sell their soy beans. All these factors forced the price of US soy beans up some more. When they reached the level of $14.00 per bushel, the speculator decided it was time to take his profits. The option that he bought for .40 cents per bushel for the $11.00 strike price was now worth $3.00. Remember a contract is 5000 bushels which is multiplied times $3.00, so the speculator made $15,000 minus the $2,000 original cost.
Now that is my kind of trade, a $13,000 return on a $2000 investment in four months. How often does this happen? The answer, of course, is not very often. If it were that easy, everyone would be doing it, running up the price of the futures or the options. Had the soy bean market remained unchanged or gone down, the $2000 option would gradually have melted away to nothing. Occasionally the market will trade in your favor for a while, teasing you with dreams of a big time winner, but about 80 to 85% of options expire worthless.
If option buyers lose 85% of the time, who wins on the other side? Well, for every buyer there is a seller. To sell an option, the exchanges and clearing houses require that you have a lot more money because your risk is theoretically unlimited if you are the seller of a call. The option seller or writer is like an insurance company who is required to pay claims when submitted by the insurance policy owner. The option purchaser is like the buyer of an insurance policy. Most option writers are professional traders with years of experience. That does not mean all of their trades make money, and they are usually there every day monitoring their open positions. Selling calls can be very dangerous since you are shorting at the strike price which you sell, and you have unlimited risk since there is no limit how high a stock or commodity goes.