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Trading commodity options vs. futures

Chris McKhann (chris.mckhann@optionmonster.com)

Option trading can be a great way to approach any market, but there are important differences when it comes to using them on futures.

Commodity markets are increasingly appealing to traders and investors, as evidenced by the growing number of exchange-traded funds that are based on them. The earliest are still the biggest, such as the SPDR Gold Shares Fund, the U.S. Oil Fund, and the U.S. Natural Gas Fund.

All of those ETFs see regular option activity. But there are reasons that some may want to trade the actual futures instead of their funds.

One factor is that such funds typically suffer from negative roll yield . Problems such as this are the basis for the difficulty that options on futures can present. While equity options have one underlying, futures options have a different underlying for each month.

The only example that can be found in equities are the CBOE Volatility Index options. The VIX options are not based on the spot index, but on the VIX futures. While the spot VIX closed yesterday at 18.72, the July futures closed at 19.25, the August futures at 21.20, and the September futures at 22.65.

Even though that so-called term structure has been rather flat lately, the September futures are still more than 20 percent above the value of the spot index. That obviously can make a very big difference in the option price, most clearly seen in the puts.

In any equity name with a single underlying, the further out in time you go, the more expensive the puts tend to become. But in this case, the July 19 puts are $1.20 while the August puts are a rare $1.45, the September and November contracts are both $1.30, and the Decembers are $1.20.

This is because not all futures move in lockstep, and the dynamics vary from in different markets. Some have seasonal dynamics, for example, while others--such as the VIX--are always more volatile in nearer months.

That is probably the biggest issue that new traders face in futures options. It makes the proper implied volatility data all that much more important to determine the relative value of the options.

There are other key issues as well. The contracts' specifications are very important to understand how much you are paying and how much of the underlying you potentially control. And settlement will tell you if you'll end up with cash if you are exercised or a load of oil at your door.

For these reasons, trading futures directly can be the best way to get the exposure that you want in commodities. (That is often what I do.) But you had better be willing to do the research so that you fully understand what you are getting and how you are getting it.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of July 11.)

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