Options and Futures FAQ
A beginner's guide to understanding options contracts, covered calls, and futures trading.
Options FAQ
What is a covered call and what's the point?
The point of a covered call is to generate income by selling out-of-the-money calls on stock you already own. You're selling options that you hope expire worthless so you can make a profit on the premium you charged to sell them.
A covered call is like a secured credit card in that it's backed by stocks you already own. You have to sell the stocks if the options are in the money when they mature/expire (and the option holder decides to exercise), so this guarantees that you'll be able to sell them.
Choosing strike price/expiration: A balancing act between getting a high enough premium and not giving too much time for the underlying asset to go above the strike price. Typically look for 20-50 days out for expiration.
You can use the "delta" of a given strike price/expiration date combination as a proxy for the likelihood that an option will expire in the money.
What determines the price of an option contract?
An option is a derivative, which means its price is derived from the price of its underlying asset (stock, ETF, etc.).
The price is determined by:
- Price of the underlying asset
- Volatility of the underlying asset's price (implied volatility)
- Biotech and highly competitive tech stocks are more risky than blue-chip stocks with steady dividends
- Time to expiration
- Closer to expiration = less likely to find a buyer = lower value
- Further from expiration = more likely for major price shift = higher premium
Important things to remember when trading options
You don't profit just because the strike price is lower/higher than the market price. Factor in:
- The premium you paid to own the contract
- Broker fees on the sell
Profit = Sell price - broker fee - premium price
What does "in the money" (ITM) or "out of the money" (OTM) mean?
In the money: The price of the underlying security guaranteed by the contract is better than the market price.
- For calls: strike price < market price
- For puts: strike price > market price
Futures FAQ
What is a future?
A future is an agreement to buy or sell a specific amount of a commodity or financial instrument at a specific price on a specific date in the future.
How is a future different from an option?
An "option" does not require the commodities/financial instruments to be sold. It simply gives the holder the right to buy or sell at the strike price at the maturity date.
A future is an obligation to buy or sell.
How do I collect or offload the commodities when a futures contract matures?
This is known as "delivery."
- Financially settled: Settle directly into cash
- Physically settled: Settle directly into the commodity
Note: Brokers like TD Ameritrade do not allow physical delivery. Contracts must be closed before expiration or are automatically closed.
Where do I trade futures contracts?
Futures contracts are managed by exchanges. Retail investors access futures trading through brokers who are connected to physical traders on exchange floors.
Some brokers:
- TD Ameritrade (offers thinkorswim platform)
- Interactive Brokers
- TradeStation
- E*Trade
- Charles Schwab
- NinjaTrader
What is an initial margin requirement?
Brokers do not always require you to provide the full value of the futures contract upfront. The initial margin is the percentage required.
What is tick size?
The minimum price increment that a particular contract can fluctuate.
What futures markets can I trade in?
- Interest Rates
- Metals
- Currency
- Grains
- Stock Index
- Energy
- Softs
- Forest
- Livestock
What is notional value?
The current market value of the commodity represented in the futures contract.
How do I start trading futures?
Make an account with a broker like TD Ameritrade. Better yet, start with a paperMoney account to trade without real money on the line.