Futures options offer some excellent trading strategies to commodity futures traders, but this option strategy has several pitfalls. Out-of-the-money options are often considered “sucker bets” by many experienced commodity traders, while most new traders flock to out-of-the-money futures options for their limited risk and high leverage features.
As a refresher, out-of-the-money futures options are:
Call options that have strike prices above the underlying futures contract
Example: A December $5.50 corn call when the December futures contract is trading at $5.10.
or-
Put options that have strike prices below the current market price.
Example: A December $5.00 corn put when the December futures contract is trading at $5.45.
Time Decay of Out-of-the-Money Options
Time decay of options is the main reason why commodity traders lose money when they buy out-of-the-money options. Option contracts only last for a limited amount of time. Therefore, options lose value every day and that rate accelerates in the last 30 days of the option. Basically, you are placing a bet that has to pay off in a certain time frame.This means that you not only have to be correct on picking the direction of the market, but you have to be correct on the timing. For far out-of-the-money options, you will have to get a very strong move in the underlying futures market to make a decent profit on out-of-the-money options. These moves don’t happen too often, so you are buying long shots with this option strategy.
Trading Strategies With Out-of-the-Money Options
When trading out-of-the-money futures options, you should have defined trading expectations. You should expect most of your trades to be losers, but make a lot of money on a small percentage of trades. This is just the opposite of using an option selling strategy, where you expect to make money on most of your trades and guard against taking a huge loss on the inevitable trades that moves strongly against you.Some professional traders who buy out-of-the-money options strongly guard against losing time value. Therefore, if the market doesn’t move in their favor quickly, they exit the positions. This way, there is still limited risk with a lot of leverage.
Also realize that commissions will be a bigger percentage of the option value when you buy out-of-the-money futures options, because they are priced lower than-in-the-money options. This can be very costly if you are paying higher full service rates.
