Options 101

Not sure if trading metals options on Comex or the LME is right for you? Here’s an overview of how this financial tool works, plus a look at its pitfalls and possibilities.

By George Kleinman

George Kleinman is president of Commodity Resource Corp. (Incline Village, Nev.). A 20-year member of the New York Mercantile Exchange, Comex division, he has been trading futures and commodities for himself and on behalf of individuals and commercial clients since 1977.

This article was written partially in response to the March/April 2001 article, “Taming Risk,” which suggested that options are too risky and complicated for the scrap industry to use.

There seem to be two schools of thought about the financial tool known as options, which scrap dealers can use either to hedge or speculate on the exchange-traded metals markets like Comex and the LME. Some see options as the “best of both worlds,” promising unlimited profit potential with limited risk. Others say they are simply too hard to understand.
   As with every financial instrument, the reality is that there are both advantages and disadvantages to using options. Certainly, they aren’t the proverbial free lunch. So you’ll have to decide for yourself whether the potential benefits of options outweigh the possible drawbacks.

Coming to Terms
First, some definitions. An option is a financial instrument that gives the buyer the right—but not the obligation—to buy or sell a stated quantity of a commodity at a specified price on or before a specific date in the future. Active exchange-traded options are available on aluminum, copper, gold, nickel, platinum, silver, and zinc.
  There are only two types of options—calls and puts—and their features are fairly straightforward. 
  Call options are bought by bullish traders. A call option gives the buyer the right, but again not the obligation, to purchase the underlying asset at an agreed-upon price (known as the strike price) within a specified time. Calls are also bought by hedgers who want to protect themselves from higher prices. For example, a consumer who likes the current aluminum price can lock it in minus the premium (the cost of buying the option) by buying short- or longer-term options.
   Put options are the mirror image of call options. A put option gives the buyer the right, but not the obligation, to sell the underlying asset at an agreed-upon price (the strike price) within a specified time. Put options are bought by bearish traders who anticipate a weaker market and who want to protect against a fall in the future price (for example a scrap dealer afraid of falling prices in the future who wants to protect his inventory).
   What is the underlying asset? For exchange-traded options, it’s the corresponding futures contract. Options can be converted into the underlying futures contract at the discretion of the buyer—this is called the right to exercise and it explains why the size of every option is the same as the contract it represents. One copper option, for instance, is for 25,000 pounds of high-grade copper, while one aluminum option represents 25 mt (55,100 pounds) of aluminum.
   By exercising an option, the buyer receives either a long or short position at the option’s strike price. An owner of a call option who exercises his option receives a long futures position. An owner of a put who exercises his option receives a short futures position. It’s important to remember that options, like futures, trade in designated contract months. So be sure to check the option’s expiration date since, in many cases, the options expire in the month preceding the futures they correspond to—December copper options, for example, expire near the end of November.

High and Low Points
The primary advantage of options is that they limit risk. Unlike buying futures, the most you can ever lose as an option buyer is what you originally paid for the option—the one-time premium. You could lose even less than that by selling out prior to expiration, or you could make a significant profit trading options. 
   The best aspect of options, though, is that you have a clearly defined maximum risk. Thus, you know to the penny what the worst-case scenario is right from the start. The same is not true with futures.
The primary disadvantage of options is that the premium must be paid up front, and the cost must be recovered in part or in whole via a favorable movement in price; otherwise, you lose money on the deal. You can even correctly predict the market’s direction when buying options and still lose money if the market doesn’t move far enough.
   Look at it this way: If you buy a copper option good for the current market price of, say, $1,000 and the market goes nowhere—that is, it stays at the same price for the life of the option—you lose your $1,000 premium. The market moved nowhere, and the seller of the option keeps your $1,000. For the seller of the option to profit, he only needs a stationary market, a move in his direction, or a move that does not cover the premium in full.
   If, instead, you bought a futures contract and held it for the same time period, you would have lost only the commission costs. In this case, the “limited-risk” option was more costly than the “higher-risk” futures contract.
   Of course, in this simplistic example we do not know what transpired in the interim period. The market could have sold off wildly—resulting in a margin call that required the futures trader to deposit more money to maintain his position—and then recovered. As a result, the futures trader could have been forced to pay out considerable sums, perhaps more than once (or lose his position), while the option trader (who is not subject to margin calls) could just sit out these price gyrations.
   So you see, there are no easy answers here.

Putting Options to Work
Here’s how a typical option works: Let’s say you are bullish aluminum and want to play this market using options. Since you are confident the price will rise, you would buy a call option.
   Suppose it’s January and the LME three-month aluminum price is $1,600 a mt. You can buy an “April 1600” call for, say, $40 a mt or $1,000 for one option ($40 a mt x 25 mt = $1,000). 
   This option gives you the right, but not the obligation, to buy an April futures contract at a price of $1,600 at any time prior to the expiration date in mid-April.
   At the same time, you could buy an April 1650 call, which would cost you less than the 1600 call, or an April 1550 call, which would cost you more. How do you determine which option is best for you to buy? The answer differs from investor to investor and depends on a number of issues and factors.
   Time, for instance. You have to decide how much time you want to pay for. A basic rule is that the more time you want the option to have before it expires, the higher the premium you’ll pay.
   And then there’s “time decay.” All else being equal, the time value of an option decreases slightly each day (providing there is still a reasonable amount of time left until expiration). The rate of this decrease becomes more rapid as the option gets closer to expiration. This is termed the normal time decay, which works to the detriment of the buyer and the benefit of the seller. As an option gets close to expiration, an option’s time value becomes less and less. What matters most at this juncture is the relationship between the strike price and the underlying commodity. That’s because, at expiration, the option can only be worth something or nothing—that’s it. Don’t forget, you might buy a call because you thought a particular metal would increase in price, but you could show a loss even if you are right. How? Because the price didn’t rise enough to compensate for the time it took to occur.
   Also, you need to understand what it means to be “in the money,” “out of the money,” or “at the money.” 
When the market is at $1,600, for instance, a 1550 call is “in the money” by $50, and thus the premium for this option will be more expensive than the 1650 call that is “out of the money” by $50. The 1600 call, of course, is “at the money” because the option is right at the strike price.
   If you look at an options price table, you’ll see listings for different months out into the future. Under each month are a variety of strike prices at which the options can be exercised. This is an important feature that makes options on futures more complicated than futures themselves.
   Consider our aluminum example: You are bullish and decided to purchase the April 1600 call when the LME’s three-month aluminum contract was trading at $1,600 a mt. April aluminum futures subsequently rise to $1,650. At this point, the option has intrinsic value because the price of the underlying asset (in this case, April aluminum) is above the strike price. At $1,650, the April 1600 call has $50 of intrinsic value and, as explained before, is considered “in the money” by $50. Since one option is for 25 mt and every $1 is worth $25 per option, the value of this option will be at least $1,250 ($50 x $25 a mt = $1,250).
   Here’s another way to look at this: When the current price is $1,650, the right to buy a call at $1,600 must be worth at least $50 since it is already profitable by this amount. It could be worth more, of course, if there is still time value. (Time value is that portion of the premium price other than intrinsic value. It is dependent on how much time remains until expiration.)
   An option’s value is also determined by market volatility. Simply put, as the volatility of a market increases, so will the option’s premium. That’s because option sellers demand higher premiums to offset the higher risks to them that options entail in a more volatile environment. Conversely, sleepy markets supposedly have lower potential price movements and so option buyers bid less and the market demands lower premiums.

A Floor But No Ceiling
For scrap dealers, hedging with options offers an opportunity to reap profits that are unavailable from hedging with futures. That’s because futures hedging is designed primarily to offset risk, locking in a guaranteed profit today—albeit a sometimes smaller profit than you might have made without the futures hedge.
   But scrap dealers know all too well how risky the metals business can be. So if there is the possibility of a larger profit, they often need it to offset periods of losses or marginal gains.
   Here’s how a scrap dealer can use options to his advantage: Let’s say that the dealer knows that his break-even price for selling copper is 80 cents a pound. The dealer begins by buying a put for 120-day Comex copper at a strike price of 83 cents, for which he paid a premium of 3 cents a pound. He has now locked in a selling price of 80 cents (83 - 3 = 80). 
   If copper prices then fall to 76 cents at expiration, when his sale takes place, he loses 4 cents a pound in the cash market because his break-even point was 80 cents a pound. But his option is now worth 7 cents (the 83-cent strike price minus the current market price of 76 cents) for a net profit of 4 cents before commissions (recall that he paid a premium of 3 cents a pound).
   Add the 4-cent profit back to the 76-cent price and the scrap dealer, in effect, gets back to his break-even point of 80 cents, meaning that his worst-case scenario is simply one in which he neither makes nor loses money on the deal. Essentially, he gives up 3 cents of potential profit for the security of avoiding catastrophic loss.
   Of course, hedging with futures provides much the same security against downside risk, but the futures hedge also places a ceiling on the potential for upside profit. Options, however, guarantee a price floor—a worst-case scenario no matter how far prices fall—without restricting the potential for profit.
   If, for instance, copper prices rise to 85 cents a pound, the scrap dealer reaps a 5-cent profit in the cash market (which would be reduced to 2 cents because of the 3-cent premium, of course). If prices reach 88 cents, the dealer earns 5 cents a pound after the premium, 90 cents produces a 7-cent gain, and so on, with no upside 
restrictions.
   The bottom line is that options offer recyclers a powerful tool with which they can limit losses while still enjoying those rare moments of windfall profits that are so necessary to offset mediocre markets and outright downturns. 
   Options definitely belong in the scrap dealer’s financial toolbox. n

Editor’s note: George Kleinman can be reached at P.O. Box 8700, Incline Village, NV 89452-8700; 800/233-4445 or 775/833-2700 (fax, 775/833-1400); or e-mail geo@commodity.com. To learn more about his company Commodity Resource Corp., visit www.commodity.com.