Buying a Put Option

An option is a right, but not an obligation, to execute an action on a trade. A put option is one side of a trade where a trader forces the sale of the futures contract on the buyer for the agreed-upon price. Placed strategically, a put can save a trader from a loss, or create gains.

Learn what a put option is and how it can be used in commodity futures trading.

What Is a Put Option?

Not all traders have the ability or desire to store and resell physical commodities. To benefit from commodities markets, they trade futures options—securities derived from the physical commodities traded on a commodities exchange.

When futures contracts are made, traders can purchase or sell options on them, betting that the commodity's price will move in their favor. When a trader buys a put option, they are "putting" the contract to the investing counterparty at a set price before an expiration date.

An investor would buy a put option if they expected the underlying futures contract price to move lower (decrease by the sell date). For example, if you buy a United States 12 Month Oil Fund (USL) July 22 put, you're purchasing the right to sell the contract at $22 (your "strike price") before July.

How to Buy the Right Put

Consider the following things when determining which put option to buy:

• The duration of time you plan on being in the trade
• The amount of money you can allocate toward buying the option
• The length of move you expect from the market

Most futures exchanges have a wide range of options in different expiration months and different strike prices that enable you to pick an option that meets your objectives.

Duration of Time

If an investor expects that the underlying commodity price movement would be within two weeks, they often choose to purchase its put contracts with a minimum of two weeks remaining.

Typically, investors who are planning on being in a trade for only a couple of weeks don’t buy options contracts with expirations within six to nine months. This is because the options will be more expensive because of the time premium—their value based on how much time they have left before expiration.

One factor to be aware of is that the time premium of options decays more rapidly in the last 30 days. Therefore, you could be right on a trade, but the option could lose too much time value, and you still would end up with a loss.

Amount You Can Allocate

Determining how much capital you can allocate to trading options can be challenging. One general rule of thumb for options traders is never to use more than 2 percent of your trading capital to purchase an option.

For instance, a put option for May West Texas Intermediate (WTI) Crude Oil with a strike price of $60 might cost $1,280. You could purchase one put option and sell it for $1,290 at the end of the day. Your profit would be $10, but if you were to buy more options, you would multiply your gains (or losses).

Following the 2 percent rule, you'll need to have $65,500 in your trading account for one put option. Multiply this by the number of options you'd like to purchase, and you can see how much capital you'll need for options trading.

Market Movement

Option price movements occur when the underlying commodity price changes. Commodity markets are volatile in that prices can vary quickly due to many factors. Current economic factors can cause commodity markets to trend up or down.

The way you trade options depends upon the way the market is trending. A put option is a bet that the market will trend downward, allowing the trader to make money from the change. You should plan your put options during trends where you are sure you'll sell them for more than you bought them for.

Risk Tolerance

Depending on your account size and risk tolerance, some options may be too expensive for you to buy. "In-the-money" put options (where the strike price is greater than the market price) will be more costly than "out-of-the-money" options (where the strike price is less than the market price).

Unlike with futures contracts, there is no margin when you buy futures options; you have to pay the whole option premium upfront. Therefore, options on volatile markets like crude oil futures can cost several thousand dollars.

Even if you have the money, you wouldn't want to buy deep out-of-the-money options just because they are in your price range. Most deep out-of-the-money put options (significantly lower than market price) will expire as worthless, and they are considered long shots.

The more conservative approach is usually to buy in-the-money options. The more aggressive approach is to buy multiple contracts of out-of-the-money options. Your returns will increase with numerous contracts of out-of-the-money options if the market makes a large move lower. It is also riskier, as you have a greater chance of losing the entire option premium if the market doesn’t move.

Put Options vs. Futures Contracts

Futures contracts—and, consequently, options—can be based on various assets or financial markers, including interest rates, stock indexes, currencies, energy, and agricultural and metal commodities.

As is the case when buying any options contracts, your potential losses on buying a put option are limited to the premium you paid for the option, plus commissions and any fees. With a futures contract, you have virtually unlimited loss potential.

Put options also do not move in value as quickly as futures contracts do, unless they are "deep in the money." That lower volatility allows a commodities trader to ride out many of the ups and downs in the markets that might force him to close a futures contract to limit risk.

One of the major drawbacks to buying options is the fact that they lose time value every day. Time value is a wasting asset—options are theoretically worth less after each day that passes. You have to be correct about not only the direction of the market but also the timing of the move.

The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.