Hedging Against Rising Coal Prices Using Coal Futures

Hedging Against Rising Coal Prices using Coal
Futures
Businesses that need to buy significant quantities of coal can hedge against rising coal price by taking up a
position in the coal futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of coal
that they will require sometime in the future.
To implement the long hedge, enough coal futures are to be purchased to cover the quantity of coal required by
the business operator.
Coal Futures Long Hedge Example

A power company will need to procure 155,000 tons of coal in 3 months' time. The prevailing spot price for coal is
USD 74.45/ton while the price of coal futures for delivery in 3 months' time is USD 74.00/ton. To hedge against a
rise in coal price, the power company decided to lock in a future purchase price of USD 74.00/ton by taking a
long position in an appropriate number of NYMEX Coal futures contracts. With each NYMEX Coal futures
contract covering 1550 tons of coal, the power company will be required to go long 100 futures contracts to
implement the hedge.
The effect of putting in place the hedge should guarantee that the power company will be able to purchase the
155,000 tons of coal at USD 74.00/ton for a total amount of USD 11,470,000. Let's see how this is achieved by
looking at scenarios in which the price of coal makes a significant move either upwards or downwards by delivery
date.
Scenario #1: Coal Spot Price Rose by 10% to USD 81.90/ton on Delivery Date
With the increase in coal price to USD 81.90/ton, the power company will now have to pay USD 12,693,725 for
the 155,000 tons of coal. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD
81.90/ton. As the long futures position was entered at a lower price of USD 74.00/ton, it will have gained USD
81.90 - USD 74.00 = USD 7.8950 per ton. With 100 contracts covering a total of 155,000 tons of coal, the total
gain from the long futures position is USD 1,223,725.
In the end, the higher purchase price is offset by the gain in the coal futures market, resulting in a net payment
amount of USD 12,693,725 - USD 1,223,725 = USD 11,470,000. This amount is equivalent to the amount
payable when buying the 155,000 tons of coal at USD 74.00/ton.
Scenario #2: Coal Spot Price Fell by 10% to USD 67.01/ton on Delivery Date
With the spot price having fallen to USD 67.01/ton, the power company will only need to pay USD 10,385,775 for
the coal. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the coal futures price will have converged with the coal spot price and will be equal to
USD 67.01/ton. As the long futures position was entered at USD 74.00/ton, it will have lost USD 74.00 - USD
67.01 = USD 6.9950 per ton. With 100 contracts covering a total of 155,000 tons, the total loss from the long
futures position is USD 1,084,225
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in
the coal futures market and the net amount payable will be USD 10,385,775 + USD 1,084,225 = USD
11,470,000. Once again, this amount is equivalent to buying 155,000 tons of coal at USD 74.00/ton.
Hedging Against Falling Coal Prices using Coal
Futures
Coal producers can hedge against falling coal price by taking up a position in the coal futures market.
Coal producers can employ what is known as a short hedge to lock in a future selling price for an ongoing
production of coal that is only ready for sale sometime in the future.
To implement the short hedge, coal producers sell (short) enough coal futures contracts in the futures market to
cover the quantity of coal to be produced.
Coal Futures Short Hedge Example

A coal mining firm has just entered into a contract to sell 155,000 tons of coal, to be delivered in 3 months' time.
The sale price is agreed by both parties to be based on the market price of coal on the day of delivery. At the time
of signing the agreement, spot price for coal is USD 74.45/ton while the price of coal futures for delivery in 3
months' time is USD 74.00/ton.
To lock in the selling price at USD 74.00/ton, the coal mining firm can enter a short position in an appropriate
number of NYMEX Coal futures contracts. With each NYMEX Coal futures contract covering 1,550 tons of coal,
the coal mining firm will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the coal mining firm will be able to sell the 155,000
tons of coal at USD 74.00/ton for a total amount of USD 11,470,000. Let's see how this is achieved by looking at
scenarios in which the price of coal makes a significant move either upwards or downwards by delivery date.
Scenario #1: Coal Spot Price Fell by 10% to USD 67.01/ton on Delivery Date
As per the sales contract, the coal mining firm will have to sell the coal at only USD 67.01/ton, resulting in a net
sales proceeds of USD 10,385,775.
By delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD
67.01/ton. As the short futures position was entered at USD 74.00/ton, it will have gained USD 74.00 - USD
67.01 = USD 6.9950 per ton. With 100 contracts covering a total of 155000 tons, the total gain from the short
futures position is USD 1,084,225
Together, the gain in the coal futures market and the amount realised from the sales contract will total USD
1,084,225 + USD 10,385,775 = USD 11,470,000. This amount is equivalent to selling 155,000 tons of coal at
USD 74.00/ton.
Scenario #2: Coal Spot Price Rose by 10% to USD 81.90/ton on Delivery Date
With the increase in coal price to USD 81.90/ton, the coal producer will be able to sell the 155,000 tons of coal for
a higher net sales proceeds of USD 12,693,725.
However, as the short futures position was entered at a lower price of USD 74.00/ton, it will have lost USD 81.90
- USD 74.00 = USD 7.8950 per ton. With 100 contracts covering a total of 155,000 tons of coal, the total loss
from the short futures position is USD 1,223,725.
In the end, the higher sales proceeds is offset by the loss in the coal futures market, resulting in a net proceeds of
USD 12,693,725 - USD 1,223,725 = USD 11,470,000. Again, this is the same amount that would be received by
selling 155,000 tons of coal at USD 74.00/ton.
Coal Futures Trading
Consumers and producers of coal can manage coal price risk by purchasing and selling coal futures. Coal
producers can employ a short hedge to lock in a selling price for the coal they produce while businesses that
require coal can utilize a long hedge to secure a purchase price for the commodity they need.
Coal futures are also traded by speculators who assume the price risk that hedgers try to avoid in return for a
chance to profit from favorable coal price movement. Speculators buy coal futures when they believe that coal
prices will go up. Conversely, they will sell coal futures when they think that coal prices will fall
Buying (Going Long) Coal Futures to Profit from

a Rise in Coal Prices
If you are bullish on coal, you can profit from a rise in coal price by taking up a long position in the coal futures
market. You can do so by buying (going long) one or more coal futures contracts at a futures exchange.
Example: Long Coal Futures Trade
You decide to go long one near-month NYMEX Coal Futures contract at the price of USD 74.45 per ton. Since
each NYMEX Coal Futures contract represents 1550 tons of coal, the value of the futures contract is USD
115,398. However, instead of paying the full value of the contract, you will only be required to deposit an initial
margin of USD 18,900 to open the long futures position.
Assuming that a week later, the price of coal rises and correspondingly, the price of coal futures jumps to USD
81.90 per ton. Each contract is now worth USD 126,937. So by selling your futures contract now, you can exit
your long position in coal futures with a profit of USD 11,540.
Long Coal Futures Strategy: Buy LOW, Sell HIGH
BUY 1550 tons of coal at USD 74.45/ton USD 115,398
SELL 1550 tons of coal at USD 81.90/ton USD 126,937
Profit USD 11,540
Investment (Initial Margin) USD 18,900
Return on Investment 61.06%
Margin Requirements & Leverage

In the examples shown above, although coal prices have moved by only 10%, the ROI generated is 61.06%. This
leverage is made possible by the relatively low margin (approximately 16.38%) required to control a large amount
of coal represented by each contract.
Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is
favorable towards you. If the market turn against you, you will be required to top up your account to meet the
margin requirements in order for your futures position to remain open.
Selling (Going Short) Coal Futures to Profit
from a Fall in Coal Prices
If you are bearish on coal, you can profit from a fall in coal price by taking up a short position in the coal futures
market. You can do so by selling (shorting) one or more coal futures contracts at a futures exchange.
Example: Short Coal Futures Trade
You decide to go short one near-month NYMEX Coal Futures contract at the price of USD 74.45/ton. Since each
Coal futures contract represents 1550 tons of coal, the value of the contract is USD 115,398. To enter the short
futures position, you have to put up an initial margin of USD 18,900.
A week later, the price of coal falls and correspondingly, the price of NYMEX Coal futures drops to USD 67.01 per
ton. Each contract is now worth only USD 103,858. So by closing out your futures position now, you can exit your
short position in Coal Futures with a profit of USD 11,540.
Short Coal Futures Strategy: Sell HIGH, Buy LOW
SELL 1550 tons of coal at USD 74.45/ton USD 115,398
BUY 1550 tons of coal at USD 67.01/ton USD 103,858
Profit USD 11,540
Investment (Initial Margin) USD 18,900
Return on Investment 61.06%
Margin Requirements & Leverage

In the examples shown above, although coal prices have moved by only 10%, the ROI generated is 0.00%. This
leverage is made possible by the relatively low margin (approximately 16.38%) required to control a large amount
of coal represented by each contract.
Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is
favorable towards you. If the market turn against you, you will be required to top up your account to meet the
margin requirements in order for your futures position to remain open.
Long Futures Position
The long futures position is an unlimited profit, unlimited risk position that can be entered by the futures
speculator to profit from a rise in the price of the underlying.
The long futures position is also used when a manufacturer wishes to lock in the price of a raw material that he
will require sometime in the future. See long hedge.
Long Futures Position Construction
Buy 1 Futures Contract
To construct a long futures position, the trader must have enough balance in his account to meet the initial
margin requirement for each futures contract he wishes to purchase.
Unlimited Profit Potential

There is no maximum profit for the long futures position. The futures trader stands to profit as long as the
underlying futures price goes up.
The formula for calculating profit is given below:
Maximum Profit = Unlimited
Profit Achieved When Market Price of Futures > Purchase Price of Futures
Profit = (Market Price of Futures - Purchase Price of Futures) x Contract Size
Unlimited Risk
Large losses can occur for the long futures position if the underlying futures price falls dramatically.
The formula for calculating loss is given below:
Maximum Loss = Unlimited
Loss Occurs When Market Price of Futures < Purchase Price of Futures
Loss = (Purchase Price of Futures - Market Price of Futures) x Contract Size + Commissions Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the long futures position position can be calculated using
the following formula.
Breakeven Point = Purchase Price of Futures Contract
Example
Suppose June Crude Oil futures is trading at $40 and each futures contract covers 1000 barrels of Crude Oil. A
futures trader enters a long futures position by buying 1 contract of June Crude Oil futures at $40 a barrel.
Scenario #1: June Crude Oil futures rises to $50
If June Crude Oil futures instead rallies to $50 on delivery date, then the long futures position will gain $10 per
barrel. Since the contract size for Crude Oil futures is 1000 barrels, the trader will achieve a profit of $10 x 1000 =
$10000.
Scenario #2: June Crude Oil futures drops to $30
If June Crude Oil futures is trading at $30 on delivery date, then the long futures position will suffer a loss of $10 x
1000 barrel = $10000 in value.
Daily Mark-to-Market & Margin Requirement

The value of a long futures position is marked-to-market daily. Gains are credited and losses are debited from the
future trader's account at the end of each trading day.
If the losses result in margin account balance falling below the required maintenance level, a margin call will be
issued by the broker to the futures trader to top up his or her account in order for the futures position to remain
open.
Synthetic Long Futures

An equivalent position known as a synthetic long futures position can be constructed using only options.
Short Futures Position
The short futures position is an unlimited profit, unlimited risk position that can be entered by the futures
speculator to profit from a fall in the price of the underlying.
The short futures position is also used by a producer to lock in a price of a commodity that he is going to sell in
the future. See short hedge.
Short Futures Position Construction
Sell 1 Futures Contract
To create a short futures position, the trader must have enough balance in his account to meet the initial margin
requirement for each futures contract he wishes to sell.

There is no maximum profit for the short futures position. The futures trader stands to profit as long as the
underlying asset price goes down.
Profit Achieved When Market Price of Futures < Selling Price of Futures
Profit = (Selling Price of Futures - Market Price of Futures) x Contract Size
Unlimited Risk
Heavy losses can occur for the short futures position if the underlying asset price rises dramatically.

Loss Occurs When Market Price of Futures > Selling Price of Futures
Loss = (Market Price of Futures - Selling Price of Futures) x Contract Size + Commissions Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the short futures position position can be calculated using
the following formula.
Breakeven Point = Selling Price of Futures Contract
Example
futures trader enters a short futures position by selling 1 contract of June Crude Oil futures at $40 a barrel.
If June Crude Oil futures is trading at $30 on delivery date, then the short futures position will gain $10 per barrel.
Since the contract size for Crude Oil futures is 1000 barrels, the trader will net a profit of $10 x 1000 = $10000.
If June Crude Oil futures instead rallies to $50 on delivery date, then the short futures position will suffer a loss of
$10 x 1000 barrel = $10000 in value.
Daily Mark-to-Market & Margin Requirement

The value of a short futures position is marked-to-market daily. Gains are credited and losses are debited from
the future trader's account at the end of each trading day.
If the losses result in margin account balance falling below the required maintenance level, a margin call will be
issued by the broker to the futures trader to top up his or her account in order for the futures position to remain
open.
Synthetic Short Futures

An equivalent position known as a synthetic short futures position can be constructed using only options.
Futures Basis
The basis reflects the relationship between cash price and futures price. (In futures trading, the term "cash" refers
to the underlying product). The basis is obtained by subtracting the futures price from the cash price.
The basis can be a positive or negative number. A positive basis is said to be "over" as the cash price is higher
than the futures price. A negative basis is said to be "under" as the cash price is lower than the futures price.
Basis Calculation Example
Spot (Cash) Price $42

August Futures Price $47
Basis -5 (In market lingo, the basis is "$5 under August".)
Strong or Weak Basis

The basis changes from time to time. If the basis gains in value (say from -4 to -1), we say the basis has
strengthened. On the other hand, if basis drops in value (say from 8 to 2), we say the basis has weakened.
Short term demand and supply situations are generally the main factors responsible for the change in the basis.
If demand is strong and the available supply small, cash prices could rise relative to futures price, causing the
basis to strengthen. On the other hand, if the demand is weak and a large supply is available, cash prices could
fall relative to the futures price, causing the basis to weaken.
However, although the basis can and does fluctuate, it is still generally less volatile than either the cash or futures
price.
Basis Risk
Basis risk is the chance that the basis will have strengthened or weakened from the time the hedge is
implemented to the time when the hedge is removed. Hedgers are exposed to basis risk and are said to have a
position in the basis.
Long Basis Position
A long basis position stand to gain from a strengthening basis. Short hedges have a long basis position.
Short Basis Position
A short basis position stand to gain from a weakening basis. Long hedges have a short basis position.
Long Hedge
The long hedge is a hedging strategy used by manufacturers and producers to lock in the price of a product or
commodity to be purchased some time in the future. Hence, the long hedge is also known as input hedge.
The long hedge involves taking up a long futures position. Should the underlying commodity price rise, the gain
in the value of the long futures position will be able to offset the increase in purchasing costs.
Long Hedge Example

In May, a flour manufacturer has just inked a contract to supply flour to a supermarket in September. Let's
assume that the total amount of wheat needed to produce the flour is 50000 bushels. Based on the agreed
selling price for the flour, the flour maker calculated that he must purchase wheat at $7.00/bu or less in order to
breakeven.
At that time, wheat is going for $6.60 per bushel at the local elevator while September Wheat futures are trading
at $6.70 per bushel, and the flour maker wishes to lock in this purchase price. To do this, he enters a long hedge
by buying some September Wheat futures.
With each Wheat futures contract covering 5000 bushels, he will need to buy 10 futures contracts to hedge his
projected 50000 bushels requirement.
In August, the manufacturing process begins and the flour maker need to purchase his wheat supply from the
local elevator. However, the price of wheat have since gone up and at the local elevator, the price has risen to
$7.20 per bushel. Correspondingly, prices of September Wheat futures have also risen and are now trading at
$7.27 per bushel.
Loss in Cash Market...
Since his breakeven cost is $7.00/bu but he has to purchase wheat at $7.20/bu, he will lose $0.20/bu. At 50000
bushels, he will lose $10000 in the cash market.
So for all his efforts, the flour maker might have ended up with a loss of $10000.
... is Offset by Gain in Futures Market.
Fortunately, he had hedge his input with a long position in September Wheat futures which have since gained in
value.
Value of September Wheat futures purchased in May = $6.70 x 5000 bushels x 10 contracts = $335000
Value of September Wheat futures sold in August = $7.27 x 5000 bushels x 10 contracts = $363500
Net Gain in Futures Market = $363500 - $335000 = $28500
Overall profit = Gain in Futures Market - Loss in Cash Market = $28500 - $10000 = $18500
Hence, with the long hedge in place, the flour maker can still manage to make a profit of $18500 despite rising
Wheat prices.
Basis Risk
The long hedge is not perfect. In the above example, while cash prices have risen by $0.60/bu, futures prices
have only gone up by $0.57/bu and so the long futures position have only managed to offset 95% of the rise in
price. This is due to the strengthening of the basis.
Cash September Futures Basis
May $6.60 $6.70 -$0.10

August $7.20 $7.27 -$0.07
Net -$0.60/bu +$0.57/bu +$0.03 (Strengthened by $0.03)
The basis tracks the relationship between the cash market and the futures market. Hedgers should pay attention
to the basis when deciding when to enter the hedge as they are said to have taken up a position in the basis
once a hedge is in place. See basis.
Short Hedge
The short hedge is a hedging strategy used by manufacturers and producers to lock in the price of a product or
commodity to be delivered some time in the future. Hence, the short hedge is also known as output hedge.
The short hedge involves taking up a short futures position while owning the underlying product or commodity
to be delivered. Should the underlying commodity price fall, the gain in the value of the short futures position will
be able to offset the drop in revenue from the sale of the underlying.
Short Hedge Example

In March, a wheat farmer is planning to plant 100000 bushels of wheat, which will be ready for harvesting by late
August and delivery in September. The farmer knows from past years that the total cost of planting and
harvesting the crops is about $6.30 per bushel.
At that time, September Wheat futures are trading at $6.70 per bushel, and the wheat farmer wishes to lock in
this selling price. To do this, he enters a short hedge by selling some September Wheat futures.
With each Wheat futures contract covering 5000 bushels, he will need to sell 20 futures contracts to hedge his
projected 100000 bushels production.
By mid-August, his wheat crops are ready for harvesting. However, the price of wheat have since fallen and at
the local elevator, the price has dropped to $6.20 per bushel. Correspondingly, prices of September Wheat
futures have also fallen and are now trading at $6.33 per bushel.
Loss in Cash Market...
Selling his harvest of 100000 bushels of wheat at the local elevator yields $6.20/bu x 100000 bushels = $620000.
But the cost of growing the crops is $6.30/bu x 100000 bushels = $630000
Hence, his net profit from the farming business = Revenue Yield - Cost of Growing Crops = $620000 - $630000 =
-$10000
For all his efforts, the wheat farmer might have ended up with a loss of $10000.
... is Offset by Gain in Futures Market.
Fortunately, he had hedge his output with a short position in September Wheat futures which have since gained
in value.
Value of Wheat futures Sold in March = $6.70 x 20 contracts x 5000 bushels = $670000
Value of Wheat futures Purchased in August = $6.33 x 20 contracts x 5000 bushels = $633000
Net Gain in Futures Market = $670000 - $633000 = $37000
Overall profit = Gain in Futures Market - Loss in Cash Market = $37000 - $10000 = $27000
Hence, with the short hedge in place, the farmer can still manage to make a profit of $27000 despite falling
Wheat prices.
Basis Risk
The short hedge is not perfect. In the above example, while cash prices have fallen by $0.40/bu, futures prices
have only dropped by $0.37/bu and so the short futures position have only managed to offset 92.5% of the drop
in price. This is due to the weakening of the basis.
Cash September Futures Basis
March $6.60 $6.70 -$0.10

August $6.20 $6.33 -$0.13
Net -$0.40/bu +$0.37/bu -$0.03 (Weakened by $0.03)
The basis tracks the relationship between the cash market and the futures market. Hedgers should pay attention
to the basis when deciding when to enter the hedge as they are said to have taken up a position in the basis
once a hedge is in place.
Futures Options
A futures option, or option on futures, is an option contract in which the underlying is a single futures contract.
The buyer of a futures option contract has the right (but not the obligation) to assume a particular futures position
at a specified price (the strike price) any time before the option expires. The futures option seller must assume
the opposite futures position when the buyer exercises this right.
If you are unfamiliar with futures, it is recommended that you learn more about trading futures contracts
before continuing with the rest of this article.
Things To Note When Trading Futures Options

Expiration Dates
Futures options usually expire near the end of the month that precedes the delivery month of the underlying
futures contract (i.e. March option expires in February) and very often, it is on a Friday.
Strike Price
This is the price at which the futures position will be opened in the trading accounts of both the buyer and the
seller if the futures option is exercised.
Exercise & Assignment
When a futures option is exercised, a futures position is opened at the predetermined strike price in both the
buyer and the seller's account. Depending on whether a call or a put is exercised, the option buyer and seller will
assume either a long position or a short position.
Futures positions assumed upon option exercise
Buyer Assumes Seller Assumes
Call Option Long Futures Position Short Futures Position

Put Option Short Futures Position Long Futures Position
Futures Option Pricing
It is important to remember that the underlying of a futures options is the futures contract, not the commodity.
Hence, the option price move along with the futures price and not the commodity price. Although the futures price
tracks the commodity price closely, they are not the same. For highly leveraged products like options, the impact
of such tiny differences can be greatly magnified
The synthetic long futures is an options strategy used to simulate the payoff of a long futures position. It is
entered by buying at-the-money call options and selling an equal number of at-the-money put options of the
same underlying futures and expiration month.
Synthetic Long Futures Construction
Buy 1 ATM Call

Sell 1 ATM Put
This is an unlimited profit, unlimited risk options position that can be created to hedge a short futures position,
often as a means to profit from an arbitrage opportunity.
The synthetic long futures strategy is also used when the futures trader is bullish on the underlying futures but
seeks an alternative to purchasing the futures outright.

Similar to a long futures position, there is no maximum profit for the synthetic long futures. The futures options
trader stands to profit as long as the underlying futures price goes up.
Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid
Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid
Synthetic Long Futures Payoff Diagram
Unlimited Risk
Like the long futures position, heavy losses can occur for the synthetic long futures if the underlying futures price
falls dramatically.
Loss Occurs When Price of Underlying < Strike Price of Short Put + Net Premium Paid
Loss = Strike Price of Short Put - Price of Underlying + Net Premium Paid + Commissions Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the synthetic long futures position can be calculated
using the following formula.
Breakeven Point = Strike Price of Long Call + Net Premium Paid
Example
futures options trader enters a synthetic long futures position by selling a JUN Crude Oil 40 put for $5100 and
buying a JUN Crude Oil 40 call for $4800. The net credit received upon entering the trade is $300.
If June Crude Oil futures rallies and is trading at $50 on option expiration date, the short JUN 40 put will expire
worthless but the long JUN 40 call expires in the money and has an intrinsic value of $10000. Including the
initial credit of $300, the trader's profit comes to $10300. Comparatively, this is very close to the profit of $10000
for a long futures position.
If June Crude Oil futures is instead trading at $30 on option expiration date, then the long JUN 40 call will expire
worthless while the short JUN 40 put will expire in the money and be worth $10000. Buying back this short put
will require $10000 and subtracting the initial $300 credit taken when entering the trade, the trader's loss comes
to $9700. This amount closely approximates the $10000 loss of the corresponding long futures position.
Upfront Investment
Some novice futures traders mistakenly believe that the synthetic long futures strategy requires very little upfront
investment. They assumed that by trading options instead of futures, they can avoid posting the margin.
Unfortunately, the short put position is subjected to the same margin requirements as a short futures position.
Hence, the synthetic long futures position requires more or less the same upfront investment as a regular long
futures position.
Synthetic Long Futures (Split Strikes)

There is a less aggressive version of this strategy where both the call and put options involved are out-of-the-
money. While a larger upside movement of the underlying futures price is required to accrue large profits, this
alternative strategy does provide more room for error.
The companion strategy to the synthetic long futures is the synthetic short futures

The synthetic long futures (split strikes) is a less aggressive version of the synthetic long futures strategy.
The synthetic long futures (split strikes) position is created by buying slightly out-of-the-money calls and selling
an equal number of slightly out-of-the-money puts of the same underlying futures and expiration month.

Construction
Buy 1 OTM Call

Sell 1 OTM Put
The split strike version of the synthetic long futures strategy offers some downside protection. If the trader's
outlook is wrong and the underlying futures price falls slightly, he will not suffer any loss. On the flip side, a
stronger upside move is needed to produce a profit.
Profits and losses with a split strike strategy are also not as heavy as a corresponding long futures position as
the strategist has traded some potential profits for downside protection.

Similar to a long futures position, there is no maximum profit for the synthetic long futures (split strikes) strategy.
The options trader stands to profit as long as the underlying futures price goes up.
Profit Achieved When Price of Underlying > Strike Price of Long Call - Net Premium Received
Profit = Price of Underlying - Strike Price of Long Call + Net Premium Received
Synthetic Long Futures (Split Strikes) Payoff Diagram
Unlimited Risk
Like the long futures position, heavy losses can occur for the synthetic long futures (split strikes) if the underlying
futures price falls sharply.
Often, a credit is received when establishing this position. Hence, even if the underlying futures price remains
unchanged on expiration date, there will still be a profit equal to the initial credit received.
Loss Occurs When Price of Underlying < Strike Price of Short Put - Net Premium Received
Loss = Strike Price of Short Put - Price of Underlying - Net Premium Received + Commissions
Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the synthetic long futures (split strikes) position can be
calculated using the following formula.
Breakeven Point = Strike Price of Short Put - Net Premium Received OR Strike Price of Long Call
+ Net Premium Paid
Example
Suppose June Crude Oil futures is trading at $40 and each contract covers 1000 barrels. A trader creates a split-
strikes synthetic long futures position by selling a JUN 35 put for $2200 and buying a JUN 45 call for $2000. The
net credit taken to enter the trade is $200.
Scenario #1: June Crude Oil futures rise moderately to $45
If June Crude Oil futures rallies to $45 on option expiration date, both the short JUN 35 put and the long JUN 45
call will expire worthless and the trader gets to keep the initial credit of $200 as profit.
Scenario #2: June Crude Oil futures rallies explosively to $60
If June Crude Oil futures skyrockets to $60 on option expiration date, the short JUN 35 put will expire worthless
but the long JUN 45 call will expire in the money and has an intrinsic value of $15000. Including the initial credit
of $200, the options trader's profit comes to $15200. Comparatively, a corresponding long futures position would
have achieved a higher profit of $20000.
Scenario #3: June Crude Oil futures crashes to $20
If the price of June Crude Oil futures has instead nosedived to $20, the long JUN 45 call will expire worthless
while the short JUN 35 put will expire in the money and be worth $15000. Buying back this short put will require
$15000 and subtracting the initial $200 credit received when entering the trade, the trader's loss comes to
$14800. A heavier loss of $20000 loss would have been suffered by a corresponding long futures position.

There is a more aggressive version of this strategy where both the call and put options involved are at-the-
money. While a smaller upside movement of the underlying futures price is required to accrue large profits, this
alternative strategy provides less margin for error.

The synthetic short futures is an options strategy used to simulate the payoff of a short futures position. It is
entered by selling at-the-money call options and buying an equal number of at-the-money put options of the
same underlying futures and expiration date.
Synthetic Short Futures Construction
Buy 1 ATM Put

Sell 1 ATM Call
This is an unlimited profit, unlimited risk futures options position that can be constructed to hedge a long futures
position, often as a means to profit from an arbitrage opportunity. The synthetic short futures strategy is also used
when the futures trader is bearish on the underlying futures but seeks an alternative to selling the futures outright.

Similar to a short futures position, there is no maximum profit for the synthetic short futures. The options trader
stands to profit as long as the underlying futures price goes down.
Profit Achieved When Price of Underlying < Strike Price of Long Put + Net Premium Received
Profit = Strike Price of Long Put - Price of Underlying + Net Premium Received
Synthetic Short Futures Payoff Diagram
Unlimited Risk
Like the short futures position, heavy losses can occur for the synthetic short futures if the underlying futures
price shoots upwards.
Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received
Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received + Commissions
Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the synthetic short futures position can be calculated
using the following formula.
Breakeven Point = Strike Price of Long Put + Net Premium Received
Example
Suppose June Crude Oil futures is at $40 and each contract covers 1000 barrels of Crude Oil. An options trader
enters a synthetic short futures position by buying a JUN Crude Oil 40 put for $5100 and selling a JUL 40 call for
$4800. The net credit taken to enter the trade is $300.
If June Crude Oil futures rallies and is trading at $50 on option expiration date, the long JUN 40 put will expire
worthless but the short JUN 40 call expires in the money and has an intrinsic value of $10000. Buying back this
short call will require $10000 and subtracting the initial $300 credit taken when entering the trade, the trader's net
loss comes to $9700. Comparatively, this is very close to the net loss of $10000 for the short futures position.
If June Crude Oil futures is instead trading at $30 on option expiration day, then the short JUN 40 call will expire
worthless while the long JUN 40 put will expire in the money and be worth $10000. Including the initial $300
credit received on entering the trade, the trader's profit comes to $10300. This amount closely approximates the
$10000 gain of the corresponding short futures position.
Upfront Investment
Some novice futures traders mistakenly believe that the synthetic short futures strategy requires very little upfront
investment. They assumed that by trading options instead of futures, they can avoid posting the margin.
Unfortunately, the short call position is subjected to the same margin requirements as a long futures position.
Hence, the synthetic short futures position requires more or less the same upfront investment as a regular short
futures position.
Synthetic Short Futures (Split Strikes)

There is a less aggressive version of this strategy where both the call and put options involved are out-of-the-
money. While a larger downside movement of the underlying futures price is required to make large profits, this
split strikes strategy does provide more room for error.

The converse strategy to the synthetic short futures is the synthetic long futures, which is used when the
options trader is bullish on the underlying but seeks an alternative to purchasing the futures itself.

The synthetic short futures (split strikes) is a less aggressive version of the synthetic short futures.
The synthetic short futures (split strikes) position is created by selling slightly out-of-the-money calls and buying
an equal number of slightly out-of-the-money puts of the same underlying futures and expiration month.
Construction
Sell 1 OTM Call

Buy 1 OTM Put
The split strike version of the synthetic short futures strategy offers some upside protection. If the trader's outlook
is wrong and the underlying futures price rises slightly, he will not suffer any loss. On the flip side, a stronger
downward move is necessary to produce a profit.
Profits and losses with a split strike strategy are also not as heavy as a corresponding short futures position as
the strategist has traded some potential profits for upside protection.

Similar to a short futures position, there is no limit to the maximum possible profit for the synthetic short futures
(split strikes). The options trader stands to profit as long as the underlying futures price goes down.
Profit Achieved When Price of Underlying < Strike Price of Short Call + Net Premium Received
OR Price of Underlying < Strike Price of Long Put - Net Premium Paid
Profit = Strike Price of Long Put - Price of Underlying +/- Net Premium Received/Paid
Synthetic Short Futures (Split Strikes) Payoff Diagram
Unlimited Risk
Like the short futures position, heavy losses can occur for the synthetic short futures (split strikes) if the
underlying futures price makes a sharp move upwards.
Often, a credit is usually taken when establishing this position. Hence, even if the underlying futures price
remains unchanged on expiration date, there will still be a profit equal to the initial credit received.
Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR
Price of Underlying > Strike Price of Long Put - Net Premium Paid
Loss = Price of Underlying - Strike Price of Short Call +/- Net Premium Paid/Received +
Commissions Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the synthetic short futures (split strikes) position can be
calculated using the following formula.
Breakeven Point = Strike Price of Short Call + Net Premium Received OR Strike Price of Long Put
- Net Premium Paid
Example
Suppose June Crude Oil futures is trading at $40 and each contract covers 1000 barrels. An options trader enters
a split-strikes synthetic short futures position by buying a JUN 35 put for $2000 and selling a JUN 45 call for
$2200. The net credit received when entering the trade is $200.
Scenario #1: June Crude Oil futures falls slightly to $35
If June Crude Oil futures drops to $35 on expiration date, both the long JUN 35 put and the short JUN 45 call will
expire worthless and the trader keeps the initial credit of $200 as profit.
Scenario #2: June Crude Oil futures crashes to $20
If the price of June Crude Oil futures falls dramatically to $20, the short JUN 45 call will expire worthless while the
long JUN 35 put will expire in the money and be worth $15000. Including the initial credit of $200 received, the
options trader's net profit comes to $15200. Comparatively, a corresponding short futures position would have
achieved a greater profit of $20000.
Scenario #3: June Crude Oil futures rallies to $60
If the price of June Crude Oil futures has instead surged to $60 on option expiration date, the short JUN 35 put
will expire worthless while the long JUN 45 call will expire in the money and be worth $15000. Buying back this
long call will require $15000 and subtracting the initial $200 credit received when entering the trade, the trader's
net loss comes to $14800. A heavier loss of $20000 loss would have been suffered by a corresponding short
futures position.

There is a more aggressive version of this strategy where both the call and put options involved are at-the-
money. While a smaller downside movement of the underlying futures price is required to accrue large profits,
this alternative strategy provides less room for error
Stock Option Basics
Definition:
A stock option is a contract between two parties in which the stock option buyer (holder) purchases the right (but
not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller
(writer) within a fixed period of time.
Option Contract Specifications

The following terms are specified in an option contract.
Option Class
The two classes of stock options are puts and calls. Call options confers the buyer the right to buy the
underlying stock while put options give him the rights to sell them.
Strike Price
The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised.
It's relation to the market value of the underlying asset affects the moneyness of the option and is a major
determinant of the option's premium.
Premium
In exchange for the rights conferred by the option, the option buyer have to pay the option seller a premium for
carrying on the risk that comes with the obligation. The option premium depends on the strike price, volatility of
the underlying, as well as the time remaining to expiration.
Expiration Date
Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires,
the right to exercise no longer exists and the stock option becomes worthless. The expiration month is specified
for each option contract. The specific date on which expiration occurs depends on the type of option. For
instance, stock options listed in the United States expire on the third Friday of the expiration month.
Option Style
An option contract can be either american style or european style. The manner in which options can be exercised
also depends on the style of the option. American style options can be exercised anytime before expiration while
european style options can only be exercise on expiration date itself. All of the stock options currently traded in
the marketplaces are american-style options.
Underlying Asset
The underlying asset is the security which the option seller has the obligation to deliver to or purchase from the
option holder in the event the option is exercised. In the case of stock options, the underlying asset refers to the
shares of a specific company. Options are also available for other types of securities such as currencies, indices
and commodities.
Contract Multiplier
The contract multiplier states the quantity of the underlying asset that needs to be delivered in the event the
option is exercised. For stock options, each contract covers 100 shares.
The Options Market

Participants in the options market buy and sell call and put options. Those who buy options are called holders.
Sellers of options are called writers. Option holders are said to have long positions, and writers are said to have
short positions.
Call Option
Definition:
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a
specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price
if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the
obligation.
For stock options, each contract covers 100 shares.
Buying Call Options

Call buying is the simplest way of trading call options. Novice traders often start off trading options by buying
calls, not only because of its simplicity but also due to the large ROI generated from successful trades.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a
month's time is being priced at $2. You strongly believe that XYZ stock will rise sharply in the coming weeks after
their earnings report. So you paid $200 to purchase a single $40 XYZ call option covering 100 shares.
Say you were spot on and the price of XYZ stock rallies to $50 after the company reported strong earnings and
raised its earnings guidance for the next quarter. With this sharp rise in the underlying stock price, your call
buying strategy will net you a profit of $800.
Let us take a look at how we obtain this figure.
If you were to exercise your call option after the earnings report, you invoke your right to buy 100 shares of XYZ
stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of
$10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise
is $1000.
Since you had paid $200 to purchase the call option, your net profit for the entire trade is $800. It is also
interesting to note that in this scenario, the call buying strategy's ROI of 400% is very much higher than the 25%
ROI achieved if you were to purchase the stock itself.
This strategy of trading call options is known as the long call strategy. See our long call strategy article for a
more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven
points.
Selling Call Options

Instead of purchasing call options, one can also sell (write) them for a profit. Call option writers, also known as
sellers, sell call options with the hope that they expire worthless so that they can pocket the premiums. Selling
calls, or short call, involves more risk but can also be very profitable when done properly. One can sell covered
calls or naked (uncovered) calls.
Covered Calls
The short call is covered if the call option writer owns the obligated quantity of the underlying security. The
covered call is a popular option strategy that enables the stockowner to generate additional income from their
stock holdings thru periodic selling of call options. See our covered call strategy article for more details.
Naked (Uncovered) Calls
When the option trader write calls without owning the obligated holding of the underlying security, he is shorting
the calls naked. Naked short selling of calls is a highly risky option strategy and is not recommended for the
novice trader. See our naked call article to learn more about this strategy.
Call Spreads
A call spread is an options strategy in which equal number of call option contracts are bought and sold
simultaneously on the same underlying security but with different strike prices and/or expiration dates. Call
spreads limit the option trader's maximum loss at the expense of capping his potential profit at the same time
Put Option
Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a
specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price
if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the
obligation.
For stock options, each contract covers 100 shares.
Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he
can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below
the strike price of the put options before the option expiration date for this strategy to be profitable.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a
month's time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks
after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.
Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and
lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying
strategy will result in a profit of $800.
Let's take a look at how we obtain this figure.
If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at
$40 each. Although you don't own any share of XYZ company at this time, you can easily go to the open market
to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10
per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise
is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.
This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more
detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.
Protective Puts
Investors also buy put options when they wish to protect an existing long stock position. Put options employed in
this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index
puts.
Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as
sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling
puts, or put writing, involves more risk but can be profitable if done properly.
Covered Puts
The written put option is covered if the put option writer is also short the obligated quantity of the underlying
security. The covered put writing strategy is employed when the investor is bearish on the underlying.
Naked Puts
The short put is naked if the put option writer did not short the obligated quantity of the underlying security when
the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.
For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a
great strategy to acquire stocks at a discount.
Put Spreads
A put spread is an options strategy in which equal number of put option contracts are bought and sold
simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put
spreads limit the option trader's maximum loss at the expense of capping his potential profit at the same time.
Strike Price
Definition:
The strike price is defined as the price at which the holder of an options can buy (in the case of a call option) or
sell (in the case of a put option) the underlying security when the option is exercised. Hence, strike price is
also known as exercise price.
Strike Price, Option Premium & Moneyness

When selecting options to buy or sell, for options expiring on the same month, the option's price (aka premium)
and moneyness depends on the option's strike price.
Relationship between Strike Price & Call Option Price
For call options, the higher the strike price, the cheaper the option. The following table lists option premiums
typical for near term call options at various strike prices when the underlying stock is trading at $50
Strike Price Moneyness Call Option Premium Intrinsic Value Time Value
35 ITM $15.50 $15 $0.50
40 ITM $11.25 $10 $1.25
45 ITM $7 $5 $2
50 ATM $4.50 $0 $4.50
55 OTM $2.50 $0 $2.50
60 OTM $1.50 $0 $1.50
65 OTM $0.75 $0 $0.75
Relationship between Strike Price & Put Option Price
Conversely, for put options, the higher the strike price, the more expensive the option. The following table lists
option premiums typical for near term put options at various strike prices when the underlying stock is trading at
$50
Strike Price Moneyness Put Option Premium Intrinsic Value Time Value
35 OTM $0.75 $0 $0.75
40 OTM $1.50 $0 $1.50
45 OTM $2.50 $0 $2.50

50 ATM $4.50 $0 $4.50
55 ITM $7 $5 $2
60 ITM $11.25 $10 $1.25
65 ITM $15.50 $15 $0.50
Strike Price Intervals

The strike price intervals vary depending on the market price and asset type of the underlying. For lower priced
stocks (usually $25 or less), intervals are at 2.5 points. Higher priced stocks have strike price intervals of 5 point
(or 10 points for very expensive stocks priced at $200 or more). Index options typically have strike price intervals
of 5 or 10 points while futures options generally have strike intervals of around one or two points
Options Premium
The price paid to acquire the option. Also known simply as option price. Not to be confused with the strike price.
Market price, volatility and time remaining are the primary forces determining the premium. There are two
components to the options premium and they are intrinsic value and time value.
Intrinsic Value
The intrinsic value is determined by the difference between the current trading price and the strike price. Only in-
the-money options have intrinsic value. Intrinsic value can be computed for in-the-money options by taking the
difference between the strike price and the current trading price. Out-of-the-money options have no intrinsic
value.
Time Value
An option's time value is dependent upon the length of time remaining to exercise the option, the moneyness of
the option, as well as the volatility of the underlying security's market price.
The time value of an option decreases as its expiration date approaches and becomes worthless after that date.
This phenomenon is known as time decay. As such, options are also wasting assets.
For in-the-money options, time value can be calculated by subtracting the intrinsic value from the option price.
Time value decreases as the option goes deeper into the money. For out-of-the-money options, since there is
zero intrinsic value, time value = option price.
Typically, higher volatility give rise to higher time value. In general, time value increases as the uncertainty of the
option's value at expiry increases.
Effect of Dividends on Time Value
Time value of call options on high cash dividend stocks can get discounted while similarly, time value of put
options can get inflated. For more details on the effect of dividends on option pricing, read this article
Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock
price is expected to drop by the dividend amount on the ex-dividend date.
Meanwhile, options are valued taking into account the projected dividends receivable in the coming weeks and
months up to the option expiration date. Consequently, options of high cash dividend stocks have lower
premium calls and higher premium puts.
Effect on Call Option Pricing
Options are usually priced with the assumption that they are only exercised on expiration date. Since whoever
owns the stock as of the ex-dividend date receives the cash dividend, sellers of call options on dividend paying
stocks are assumed to receive the dividends and hence the call options can get discounted by as much as the
dividend amount.
Moneyness
Moneyness is a term describing the relationship between the strike price of an option and the current trading
price of its underlying security. In options trading, terms such as in-the-money, out-of-the-money and at-the-
money describe the moneyness of options.
In-the-Money (ITM)
A call option is in-the-money when its strike price is below the current trading price of the underlying asset.
A put option is in-the-money when its strike price is above the current trading price of the underlying asset.
In-the-money options are generally more expensive as their premiums consist of significant intrinsic value on
top of their time value.
Out-of-the-Money (OTM)
Calls are out-of-the-money when their strike price is above the market price of the underlying asset.
Puts are out-of-the-money when their strike price is below the market price of the underlying asset.
Out-of-the-money options have zero intrinsic value. Their entire premium is composed of only time value. Out-of-
the-money options are cheaper than in-the-money options as they possess greater likelihood of expiring
worthless.
At-the-Money (ATM)
An at-the-money option is a call or put option that has a strike price that is equal to the market price of the
underlying asset. Like OTM options, ATM options possess no intrinsic value and contain only time value which
is greatly influenced by the volatility of the underlying security and the passage of time.
Often, it is not easy to find an option with a strike price that is exactly equal to the market price of the underlying.
Hence, close-to-the-money or near-the-money options are bought or sold instead.
Options Expiration
All options have a limited useful lifespan and every option contract is defined by an expiration month. The option
expiration date is the date on which an options contract becomes invalid and the right to exercise it no longer
exists.
When do Options Expire?
For all stock options listed in the United States, the expiration date falls on the third Friday of the expiration
month (except when that Friday is also a holiday, in which case it will be brought forward by one day to
Thursday).
Expiration Cycles
Stock options can belong to one of three expiration cycles. In the first cycle, the JAJO cycle, the expiration
months are the first month of each quarter - January, April, July, October. The second cycle, the FMAN cycle,
consists of expiration months Febuary, May, August and November. The expiration months for the third cycle, the
MJSD cycle, are March, June, September and December.
At any given time, a minimum of four different expiration months are available for every optionable stock. When
stock options first started trading in 1973, the only expiration months available are the months in the expiration
cycle assigned to the particular stock.
Later on, as options trading became more popular, this system was modified to cater to investors' demand to use
options for shorter term hedging. The modified system ensures that two near-month expiration months will
always be available for trading. The next two expiration months further out will still depend on the expiration cycle
that was assigned to the stock.
Determining the Expiration Cycle
As there is no set pattern as to which expiration cycle a particular optionable stock is assigned to, the only way to
find out is to deduce from the expiration months that are currently available for trading. To do that, just look at the
third available expiration month and see which cycle it belongs to. If the third expiration month happens to be
January, then use the fourth expiration month to check.
The reason we need to double check January is because LEAPS expire in January and if the stock has LEAPS
listed for trading, then that January expiration month is the additional expiration month added for the LEAPS
options
Option Exercise & Assignment

Exercise
To exercise an option is to execute the right of the holder of an option to buy (for call options) or sell (for put
options) the underlying security at the striking price.
American Style vs European Style
American style options can be exercised anytime before the expiration date. European style options on the
other hand can only be exercised on the expiration date itself. Currently, all of the stock options traded in the
marketplaces are American-Style options.
When an option is exercised by the option holder, the option writer will be assigned the obligation to deliver
the terms of the options contract.
Assignment
Assignment takes place when the written option is exercised by the options holder. The options writer is said
to be assigned the obligation to deliver the terms of the options contract.
If a call option is assigned, the options writer will have to sell the obligated quantity of the underlying security at
the strike price.
If a put option is assigned, the options writer will have to buy the obligated quantity of the underlying securty at
the strike price.
Once an option is sold, there exist a possibility for the option writer to be assigned to fulfil his or her obligation to
buy or sell shares of the underlying stock on any business day. One can never tell when an assignment will take
place. To ensure a fair distribution of assignments, the Options Clearing Corporation uses a random procedure to
assign exercise notices to the accounts maintained with OCC by each Clearing Member. In turn, the assigned
firm must use an exchange approved way to allocate those notices to individual accounts which have the short
positions on those options.
Options are usually exercised when they get closer to expiration. The reason is that it does not make much
sense to exercise an option when there is still time value left. Its more profitable to sell the option instead.
Over the years, only about 17% of options have been exercised. However, it does not mean that only 17% of
your short options will be exercised. Many of those options that were not exercised were probably out-of-the-
money to begin with and had expired worthless. In any case, at any point in time, the deeper into-the-money the
short options, the more likely they will be exercised
Getting Started in Options Trading

To start trading options, you will need to have a trading account with an options brokerage. Once you have setup
your account, you can then place options trades with your broker who will execute it on your behalf.
Opening a Trading Account

When opening a trading account with a brokerage firm, you will be asked whether you wish to open a cash
account or a margin account.
Cash Account vs. Margin Account
The difference between a cash account and a margin account is that a margin account allows you to use your
existing holdings (eg. stocks or long-term options) as collaterals to borrow funds from the brokerage to finance
additional purchases. With cash accounts, you can only use the available cash in your account to pay for all your
stock and options trades.
Minimum Deposit
There is usually a minimum deposit required to open a trading account. The amount required depends on the
type of account that you are opening as well as the brokerage firm. Little or no deposit is required to open a cash
account while federal regulations require a deposit of at least $2000 to open a margin-enabled account.
Online Brokerage vs. Offline Brokerage

To trade options effectively, I find it necessary to trade via an online brokerage account as there are simply too
many variables in a typical options trade, as compared to a stock trade. Having to communicate too many details
in one trade to your broker over the phone also increases the chance of miscommunication which can prove very
costly.
With technology so advanced these days, online brokerages for options now offer highly intuitive user interfaces
where it is far easier to place option trades online than having to do it over the phone. Moreover, while a human
broker can only handle one client at a time, online brokerages can handle thousands of orders simultaneously.
Thus, it is no coincidence that the rise of option trading also coincide with the rapid advancement of internet
technologies.
Finding the Best Options Broker Online

When opening an option brokerage account, don't just go with the cheapest broker. You will find it worthwhile to
spend some time evaluating their quality of service first. Read on for tips on how to find the best online options
brokerage for your trading needs.
Full-Service Broker vs. Discount Broker
There are two main types of options brokerage firms in the market - the full service brokerage and the self-
directed discount brokerage.
Full service or traditional brokerages provide a wide range of services at extra charges. Their services include
advice to their clients on where to place their investment money.
Discount brokers are geared towards the self-directed trader. They do not provide any investment advice, leaving
their clients to make their own financial decisions. Discount brokerages merely execute your orders and
consequently their charges are much less than their full-service counterparts.
There are also brokerage companies that offer both services to their customers, letting them to choose the level
of service they require.
Most option traders that I know opt to go with the discount brokerages since anyone who is confident enough to
trade complex instruments such as options are usually financially savvy enough not to require trading advice
from their brokers, especially when the broker's renumeration is based upon the frequency of trades rather than
the quality of their recommendations.
Quality of Service
When determining which is the best options brokerage, commission charges should not be the only
consideration. When it comes to online brokers, site availability, speed of execution and ease of use are just as
important, if not more so, than price.
Availability & Speed of Execution
Site availability and responsiveness are perhaps the most crucial aspects to look out for when selecting an online
brokerage. No matter how low the commission charges, if the trade does not get through because the brokerage
site is overwhelmed by ultra high load and becomes unavailable, the amount of transaction fees you save is not
going to be worth it.
Responsiveness of the site affects the timeliness of the real-time price quotes you get. Remember, we are living
in the information age. News travel fast, round the globe, 24 hours a day. Markets react to breaking news events
faster than ever before. You don't want to be lagging, even if its just seconds behind, especially when the trading
action is fast and furious.
Note: Your own internet connection should also be up to speed. You should upgrade to a broadband connection
if you are still using dial-up. If you are using wireless, check that your connectivity is good before connecting to
the brokerage site.
Quality of Execution
The National Best Bid or Offer (NBBO) is an SEC requirement that brokers must guarantee customers the best
available ask price when they buy securities and the best available bid price when they sell securities. Look for
brokers that guarantee trade execution prices that meet or exceed the NBBO.
Ease of Use
With option trades already complicated enough on their own, it sure doesn't help when you still have to puzzle
over how to use the order placement form. An easy to understand user interface helps minimize errors, which
can be extremely costly when thousands of dollars are changing hands every trade. Look for option trading
brokerages that offer single-screen order entry forms for covered calls, condors, butterflies and other multi-legged
option strategies.
Commissions and Fees

To differentiate themselves from their competition, options trading brokerages are very creative when charging
commissions. For options trades, if you take a look at their commission and fees page, you should see two
charges: 1) a per trade fee and 2) a per contract fee.
Per Trade Fee (or Ticket Charge) - There is usually a minimum fee per transaction, regardless of how many (or
rather, how few) contracts are involved in each trade.
Per Contract Fee - This fee is charged for every option contract involved in each trade.
It is important to know how they are used to calculate the total commission costs per transaction. Usually, the
following method is used:
Total Commission = $X per Trade + $Y Per Contract
But some brokerages use the following formula:
Total Commission = $X per Trade or $Y per Contract, whichever is higher
Market or Limit Order
Some companies charges different brokerage fees for different types of orders. You should note the fee for limit
orders since you almost never place market orders.
Internet or Broker-assisted Trade
Broker assisted trades can cost as much as several times more than internet trades. The only reason to place a
broker-assisted trade is when you are cut off from the internet and a very good trading opportunity happen to
arise.
Volume Discount
There are options brokerage houses which charge a lower rate if your trading frequency exceeds a certain
threshold. So, if you are an active trader making dozens of trades a month, it makes sense to look out for a
brokerage firm that offers such a discount scheme.
Hidden Fees
To offset their low commission charges, some discount brokerage firms charges a slew of hidden fees. So if an
option brokerage charges an unusually low fee compared to the industry norms, make sure you find out whether
there are other fees that you should be aware of. Some common hidden fees include:
Account Inactivity Fee - Some brokerages charges a fee if you did not make any trade after a certain
period of time.
Annual Maintenance Fee - This is a fee levied every year as long as you have an account with the
brokerage firm, whether or not you have made any trade.
Minimum Balance Fee - This is a fee that is levied peroidically (say monthly or quarterly) when your
account balance is below a certain threshold.
Commissions can have a significant impact to an option trader's overall profit or loss, especially if your trading
capital limits you to prudently buy/sell only 1 or 2 contracts per trade or if you are just starting out and your
win/loss ratio is 6:4 or lower. Finding a low-commissions options broker can boost trading profits by as much
as 50%
How a Low Commission Broker Can Increase
Option Spreads Profits by 50% or more
Many options traders tend to overlook the effect of commission charges on their overall profit or loss. It's easy to
neglect the lowly $15 commission fee when every profitable trade nets you $500 or more. Hey, it's only 3% right?
Let's find out the answer by taking a look at a simple example using bull call spreads.
Suppose you make 10 bull call spread trades, where each trade has a maximum profit of $500 and a maximum
loss of $500. Let's say you are a decent trader using a trading system with a win rate of 60%. This means that for
every 10 trades you make, 6 are winners while 4 are losers. For simplicity's sake, let's assume that you win or
lose the maximum amount for each trade. So, for the 10 trades, your overall profit is ($500 x 6) - ($500 x 4) =
$3000 - $2000 = $1000.
Now, when it comes to calculating your trading cost, EVERY SINGLE ONE of your 10 trades will incur
commission charges.
Let's say you are using an options broker that charges you a minimum of $15 per leg per trade.
At $15 per leg, entering each of 2-legged bull call spread will require $30. Total commission charges for entering
all 10 trades will be $300. That's not all. Don't forget that the profitable bull call spreads will require closing
transactions in which you will need to buy/sell-to-close both the call option positions. With 6 profitable trades, that
means another $180 in transaction fees. Hence, your total trading cost is $300 + $180 = $480!
That takes away a whopping 48% off your trading profit!
When you implement option strategies with even more legs such as condors and butterflies, the commission
charges are even higher.
So, even if you are a skilled trader with a win rate of 70% or more, you are still better off finding a low-
commission broker if you are still paying a minimum of $15 per trade. Today, there exist online options brokers
that charge as little as $5 per trade while still providing excellent trade execution and user interface. Using the
above example, you could have increased your profit from $520 to $840 - or 62%! - simply by switching to a low
cost options broker.
Options Chain
Not all stocks have options listed for trading. There are some criterias that the public company will need to
meet before their stock options can be listed for trading. To find out whether options are available for trading, the
simplest way is to enter the stock ticker symbol to retrieve the stock quote information and find out if there is a
corresponding options chain available. The availability of an options chain will mean that there are options being
traded for that stock.
The options chain shows the available call and put strike prices for a specific underlying security and expiration
month. Depending on the online brokerage service that you use, the interface may be slightly different but in
general, the layout and available information should be very similar.
Below is the options chain interface from OptionsXpress. The most important information is shown right at the top
and they are usually the underlying security, along with its latest market price, and the expiration month. This is
common sense as you don't want to purchase an option only to realise that its for the wrong underlier or the
wrong expiration month!
Calls and Puts
Calls are usually listed on the left hand side while puts are typically displayed on the right hand side. In-the-
money options are usually highlighted to differentiate them from out-of-the-money options. If you wish to trade at-
the-money or near-the-money options, they are positioned on either side of the horizontal 'border' created by the
highlighting.
The Strike Price
Down the middle is the range of strike prices available for trading for the selected expiration month. The strike
price intervals vary and depends on the price of the underlying. For lower priced stocks (usually $25 or less),
intervals are at 2.5 points. Higher priced stocks have strike price intervals of 5 point (or 10 points for very
expensive stocks priced at $200 or more).
Options Symbol
Option symbols are unique to every option contract and they denote the type of option, the underlying asset and
the expiration month, provided you have a good understanding of options symbology. However, they are seldom
used nowadays since with modern computer technology, these information are often presented to the trader in a
user friendly interface - the options chain! While you can enter the symbol directly when placing an order, it is
advisable to select the desired options using the options chain interface to minimize human error.
Last Done Price
The last done price reflects the latest transacted price for the specific option. As the most recent transaction may
be hours or days ago, especially for thinly traded contracts, you should check the bid-ask price rather than the
last done price to get a better picture of the current market value of the option you wish to trade.
Bid-Ask Spread
The bid and ask shows the price at which buyers are willing to pay and sellers are looking to receive for the
particular option. The bid-ask spread is the difference between the bid and the ask and the size of the spread
depends on the liquidity of the option. As a general rule, the lower the open interest, the wider the bid-ask spread.
Furthermore, near the money options usually have higher open interest and hence better liquidity and narrower
bid-ask spreads.
Order Entry
Since this is a basic introduction to options trading, we will be focusing on executing simple orders that just
involve buying options.
From the options chain screen, you will have selected the option you wish to purchase by clicking on the
options symbol. A separate order entry screen will be displayed and here, you have several things to specify to
complete your order.
Quantity
After confirming the underlying security, expiration month and the strike price, the first thing you need to specify is
the quantity. For options, this is the number of contracts you wish to buy. Remember, for stock options, each
contract covers 100 shares. Commissions are charged for every contract but many brokerages offer discounts for
larger orders. Sometimes, depending on your broker, there is also a mimimum commission charge for every
order.
All or None
This option is available for limit orders. If you select this option, your broker will try to fill all of the quantity you
specified. If he is unable to do that, then none of your orders will be filled.
Options Transactions
Unlike stock trading, the contractual nature of options offer four different ways for entering and exiting positions.
There is an options seller (writer) and an options buyer (holder). The option seller can enter or exit a
transaction, and so can an option buyer.
Opening Transactions
Buy-to-Open
This is the transaction the options buyer make to enter a long position on an option. For example, if you want to
buy a call option, you would enter a "buy-to-open" transaction.
Sell-to-Open
This is the transaction the options seller make when he wish to enter a short position on an option. For example,
if you are writing call options to earn premiums, you would enter a "sell-to-open" transaction.
Closing Transactions
Buy-to-Close
This is the transaction the options writer make when he wish to exit a short position on an option. For example, if
you wish to buy back the calls you had previously sold, you would enter a "buy-to-close" transaction.
Sell-to-Close
This is the transaction the options holder make to exit a long position on an option. For example, if you want to
sell a previously purchased call option, you would enter a "sell-to-close" transaction.
Types of Orders
Online brokerages provide many types of orders to cater to the various needs of the investors. The common
types of orders available are market orders, limit orders and stop orders.
Market Order
With market orders, you are instructing your broker to buy or sell the options at the current market price. If you
are buying, you will be paying the asking price. If selling, you will be selling at the bid price. The advantage of
using market orders is that you will fill your order fast (often instantly) but the disadvantage is that you will usually
end up paying slightly more, especially when the order is large and the trading volume thin.
Limit Order
With limit orders, you will specify the price you wish to transact. If you are buying, you are instructing your broker
to buy at no higher than the specified price. If selling, you are telling him to sell at no less than your stated price.
The advantage of using limit orders is that you are in full control of the price at which you buy or sell your options.
The disadvantage is that filling the order will take some time, or the entire order may not get filled at all because
the underlying stock price has moved way beyond your desired price.
Stop Loss Order

Stop loss orders are orders that only gets executed when the market price of the underlying stock reaches a
specified price. They are used to reduce losses when the underlying asset price moves sharply against the
investor.
Stop Market Order

A stop market order, or simply stop order, is a market order that only executes when the underlying stock price
trades at or through a designated price. Buy stops, designed to limit losses on short positions, are placed above
current market price. Sell stops are used to protect long positions and are placed below current market price.
While the stop market order guarantees execution, the actual transacted price maybe slightly lower or higher
than desired, especially when the underlying price movement is very volatile.
Stop Limit Order
A stop limit order is a limit order that gets activated only when the underlying stock price trades at or through a
specified price. While a stop limit order provides complete control over the transaction price, it may not get
executed if the underlying price moves too quickly and the limit price is never reached.
Margin Requirements
In options trading, "margin" also refers to the cash or securities required to be deposited by an option writer with
his brokerage firm as collateral for the writer's obligation to buy or sell the underlying security, or in the case of
cash-settled options to pay the cash settlement amount, in the event that the option gets assigned.
Margin requirements for option writers are complicated and not the same for each type of underlying security.
They are subject to change and can vary from brokerage firm to brokerage firm. As they have significant impact
to the risk/reward profiles of each trade, writers of options (whether they be calls or puts alone or as part of
multiple position strategies such as spreads, straddles or strangles) should determine the applicable margin
requirements from their brokerage firms and be sure that they are able to meet those requirements in case the
market turns against them.

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Hedging Against Rising Coal Prices Using Coal Futures

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Hedging Against Rising Coal Prices using Coal

Coal Futures Long Hedge Example

Coal Futures Short Hedge Example

Buying (Going Long) Coal Futures to Profit from

Example: Long Coal Futures Trade

Long Coal Futures Strategy: Buy LOW, Sell HIGH

BUY 1550 tons of coal at USD 74.45/ton USD 115,398

SELL 1550 tons of coal at USD 81.90/ton USD 126,937

Profit USD 11,540

Investment (Initial Margin) USD 18,900

Return on Investment 61.06%

Margin Requirements & Leverage

Example: Short Coal Futures Trade

Short Coal Futures Strategy: Sell HIGH, Buy LOW

SELL 1550 tons of coal at USD 74.45/ton USD 115,398

BUY 1550 tons of coal at USD 67.01/ton USD 103,858

Profit USD 11,540

Investment (Initial Margin) USD 18,900

Return on Investment 61.06%

Margin Requirements & Leverage

Long Futures Position Construction

Buy 1 Futures Contract

Unlimited Profit Potential

Maximum Profit = Unlimited

Profit = (Market Price of Futures - Purchase Price of Futures) x Contract Size

Maximum Loss = Unlimited

Breakeven Point = Purchase Price of Futures Contract

Scenario #1: June Crude Oil futures rises to $50

Scenario #2: June Crude Oil futures drops to $30

Daily Mark-to-Market & Margin Requirement

Synthetic Long Futures

Short Futures Position Construction

Sell 1 Futures Contract

Unlimited Profit Potential

The formula for calculating profit is given below:

Maximum Profit = Unlimited

Profit = (Selling Price of Futures - Market Price of Futures) x Contract Size

Maximum Loss = Unlimited

Breakeven Point = Selling Price of Futures Contract

Scenario #1: June Crude Oil futures drops to $30

Scenario #2: June Crude Oil futures rises to $50

Daily Mark-to-Market & Margin Requirement

Synthetic Short Futures

Basis Calculation Example

Spot (Cash) Price $42

Strong or Weak Basis

Long Basis Position

Long Hedge Example

Loss in Cash Market...

... is Offset by Gain in Futures Market.

Cash September Futures Basis

May $6.60 $6.70 -$0.10

Short Hedge Example

Loss in Cash Market...

Cash September Futures Basis

March $6.60 $6.70 -$0.10

Things To Note When Trading Futures Options

Exercise & Assignment

Buyer Assumes Seller Assumes

Call Option Long Futures Position Short Futures Position

Futures Option Pricing

Synthetic Long Futures Construction

Buy 1 ATM Call