Options on futures are contracts that represent the right, not the obligation, to either opiton go long or sell go short a particular underlying futures contract at a specified price on or before a specified date, the expiration date. Note the difference, on the futures delivery date a physical commodity e.
There are two types of option contracts, calls and puts. Fitures and Puts: A put option conveys to its buyer the right to sell go short a particular underlying futures contract, at a stated price, on or before a specified date in the future. Options are wasting assets; they do not last forever. For example, a December corn call expires in late November. As assets with a limited time horizon, attention must be accorded to option positions. The longer the duration of an option, the more expensive it will be. The term portion of an option's premium is its time value.
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Strike Price — This is the price at which you could buy or sell the underlying futures contract. Think of it this way, the difference between a current market price and the strike price is similar to the deductible in other forms of insurance. An option's price, its premium, tracks the price of its underlying futures contract which, in turn, tracks the price of the underlying cash. Therefore, the March T-bond option premium tracks the March T-bond futures price. The May soybean option tracks the May soybean futures contract. Because option prices track futures prices, speculators can use them to take advantage of price changes in the underlying commodity, and hedgers can protect their cash positions with them.
Speculators can take outright positions in options. Options can also be used in premiun strategies with futures and cash positions. Futures options have some unique features and a set of jargon all their own. Be certain you know the exact expiration date of any option you buy.
Options often expire during the month Calculats to the delivery month of the underlying futures contract. For example, an option on a July futures contract may expire on a specified date in June. Once an option has expired, it no longer conveys any rights. It cannot be either exercised or offset.
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In effect, the option rights cease to exist and the entire investment including cxll costs is lost. Exercise — Exercising a call means that you elect to purchase the underlying futures contract at fuutres option strike price. Exercising a put means that you elect to sell the underlying futures contract at the option strike price. If you choose to exercise an option you will acquire a position in the underlying futures contract — a long position if you exercise a call, a short position if you exercise a put. In either case, acquiring a futures position and potentially unlimited risks. Offset — An option you have previously purchased can generally be liquidated offset through an offsetting transaction prior to expiration.
You will realize a net profit if the premium you receive when you liquidate the option exceeds the premium you paid for the option by an amount greater than the commission charges plus other transaction expenses. As a practical matter, most options investors choose to realize their profits or limit their losses through an offsetting sale rather than through exercise.
Calls and Puts: Obligations for Sellers
Unlike exercise, liquidating an option that you previously purchased does not involve acquiring a position in the underlying futures contract fitures, as previously mentioned, can involve substantial risk. When you purchase the rights conveyed by a particular option, it ophion to reason that there must be some other party who is Calculaet to sell those rights to cutures. In fact, that is premimu what happens, Clculate the transaction taking place on the trading floor of the exchange. The premium you pay to acquire the option rights goes to the seller who agrees to grant those rights. You should be aware that in contrast to the pre-defined and limited risk of buying options, sellers writers of options could incur potentially unlimited losses.
Selling of options is thus not suitable investment for most people. Commission — Commission is the sum of money per option purchased, that you pay to the brokerage firm for its services, including the execution of your order on the trading floor of the exchange. The commission charge is in addition to the option premium and should be separately stated. Part Two: There are two, known as intrinsic value and time value. The premium is the sum of these. Intrinsic Value Intrinsic value is the amount of money, if any, that could currently be realized by exercising the option at its strike price and liquidating the acquired futures position at the present price of the futures contract. At a time when a U.
An Option that currently has intrinsic value is said to be in the money by the amount of its intrinsic value. On the other hand, if the strike price of the call was, say Each listed option represents shares of stock known as 1 contract.
For example: ABC April 50 Call. A put option is in-the-money when the share price is below the strike price. ABC April 50 Put. The amount by which an option is in-the-money is also referred to as its intrinsic value. The Call is out-of-the-money and also has no intrinsic value. The Put is out-of-the-money and also has no intrinsic value. The Call is at-the-money and also has no intrinsic value. The Put is at-the-money and also has no intrinsic value. Remember, the total cost the price of an option contract is called the premium.
This price is determined by a few factors, including: Many companies use stock options as a way to attract and to keep talented employees, especially management. Ob are similar to regular stock options in that caall holder caol the right but not the obligation to purchase company stock. The employee stock option contract, however, exists only between the holder and the premoum. It typically cannot be exchanged with anybody else. A listed option however, is Calculte contract between two parties that is completely unrelated to the company and can be traded freely.
Why Use Options? Speculation Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. As an example: The leverage component of options contributes to their reputation for being risky. It is important to understand that when you buy an option, you must be correct in the direction of the stock's movement, and also the magnitude and timing of this movement. In other words, to succeed, you must correctly predict whether a stock will go up or down, and you have to correctly predict the magnitude of price change.
You also need to accurately predict the time frame within which all of this will happen. Hedging Options were really invented for hedging purposes.