Hobofinance

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Commodities Futures Options Lesson: Writing Call Options

January 26th, 2009 · No Comments

Writing Commodities Futures Call Options Explained:

Well, it’s 10 pm here in Shanghai. So good evening to all those in the east, and good morning to all those in the west. I’m feeling the itch to do some teaching tonight on a fascinating and sexy new commodities futures options lesson for the aspiring Hobo. Tonight we’re going to talk about writing (also known as selling) call options. (The same principles apply to Put Options, but I’ll keep with the former for the sake of simplicity and brevity). Writing call options is not a very difficult concept, but the lingo and explanation may and often does suggest otherwise. If a futures contract is an agreement between a seller of a commodity and a buyer, deliverable at some future date, and an option on a futures contract is the right, but not the obligation to buy the underlying commodity at a set price (options can be converted to futures contracts if someone wishes to take possession of a commodity once their option is in the money (or the price of the futures contract exceeds the strike price of the option), then writing (selling) a call option is selling the right to buy the underlying commodity of the contract for which you’ve written the option. That’s a mouth full and I apologize.

Perhaps it’ll make more sense if I put it another way. My friend comes over to my house and sees a car in my driveway. He likes it. He wants it. Perhaps it’s a hybrid in high demand and will be worth more in two years than it is today…he ponders. He tried to buy one and can’t. He assumes the car is mine and wants to buy it. Since my roommate is out of town, and will be for 6 months, I tell my friend, sure, why the hell not. But “I can’t give it to you today; I’ve got no other ride. I’ll need it for six months. If you give me a deposit today, I guarantee you I’ll reserve the right for you to buy the car in six months. If you change your mind however, I keep the deposit.” My friend agrees.

I’ve just sold a car I don’t own and certainly can’t afford to give. But I won’t need to. Because I know that the price of this particular car will come down within the next few months due to a ramping up of hybrid production and distribution. And perhaps there’s some kind of a financial crisis a brewing. So the odds are my friend, if still interested in purchasing that model car, will opt for a cheaper new one rather than the used one I’m selling at a higher price. My friend still owns the right to buy it, but he wouldn’t, because he’d over pay for the car and wind up with a depreciating liability. So he’d let our contract expire, leaving me with his deposit. What I just did is a metaphor for what occurs in a commodities futures options trade. My good friend bought an option (an option to buy my roommates car). In this case, the option was a call option because my friend believed the car would retain its value or appreciate in value by expiration.

This beautiful interchange, the selling of something one does not own, and may not even exist, for profit, is the quintessence of hobofinance philosophy. It’s modern day alchemy. Money from nothing…and chicks for free. I sold something I didn’t own, and I don’t go to jail. Welcome to the world of commodities futures options trading. For those bright souls that just put two and two together, yes, all the options I purchased in coffee, the ones that expired worthless, all of those were written by a person who most likely does not own a coffee futures contract. He was playing the odds and won. Most options contracts expire worthless, which means that the sellers of options are pocketing the premiums paid for those options while the buyers stay up at night and blog about how stupid they were to buy a shit load of em.

That said…there is another side to this bazaar coin. Let’s say that the next shipment of hybrids was accidentally bombed by a misguided Bush missile headed for Iraq on their way here from Germany or wherever they produce futuristic cars. The shortage of hybrids tips the supply and demand dynamic, creating an imbalance and pushing prices through the roof. Now my friend is seeing the dollar signs and feeling like a genius. And I’m sweating my balls off without a clue as to how I’m going to come up with a car for him. You see, as the price rises the likelihood of my friend calling in his call option to purchase the car increases. The other option he has, and perhaps a more favorable one for me, the poor seller, is to ask for the difference in price in cash. Let’s say the value of the car the day the option was sold was 30 grand. The current value is 40. He thinks, “I don’t want the car, so why don’t you pay me 10 grand and we’ll call it even.” This is the dreaded downside to writing options…the one time the market moves against you you’re probably going bust. Limited potential return, unlimited risk.

So how do we feel about these curious commodities futures options? On the one hand they serve no real world function. They’re a contrived derivative which usually serves as an efficient method for those in the know to fleece lots of money from newcomers. On the other hand, they provide incredible leverage, perhaps more than any other financial instrument, and can be as good as a winning lotto ticket when the right cards are dealt. And if for no other reason, there is something priceless in the notion of selling hope. An option is nothing but a promise. And that promise was never intended to be kept. A promise that made Yours Truly dive in after the dream and watch it get flushed down the toilet. But keep this in mind friends; while we’re hurting today in coffee, some other asshole out there is eating steak tonight with our sixty grand. He deserves a hobo courtesy bow…and perhaps the knife. He is the Commodities Futures Options Writer. He is the modern day alchemist!

Tags: Commodities · Financial Education

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