An option is a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a specific price on or before a given date. A call gives the option holder the right to buy, while a put gives the option holder the right to sell. The price at which the option is executed is known as the strike price.
The options holder refers to someone who buys options. Option writers are those that sell options. The option holder (buyer) has the right, but not the obligation, to buy or sell, while the option writer (seller) is obligated to buy or sell.
In addition to there being two basic types of options (calls and puts), there are also different styles of options depending on the product being traded, with different expiration procedures. American-style options can be exercised at any time prior to expiration. European-style options can only be exercised at the expiration of the option contract. Both types trade on U.S. exchanges.
Why Trade Options on Futures?
- Defined Risk: Your risk is limited to the option premium paid when buying an option. Risk is unlimited when writing an option.
- Risk Management: Options can help you protect your positions against price fluctuations when you don’t want to alter your position in the underlying.
- Trading Opportunities: A wide variety of strategies can be created using options from conservative positions to risky ones.
Premium – The cost of the option contract itself.
Strike Price – The price at which you can take a position in the underlying contract.
Underlying – The futures contract that the option is based on (i.e., March crude oil futures, December corn futures, June S&P futures, etc).
Exercise – The act of exchanging the option for a position in the underlying futures. contract. The holder of an option exercises the right to buy (in the case of calls) or sell (in the case of puts) the underlying future at the strike price.
At-the-Money – If an option is at-the-money, the option’s strike price is the same as the underlying price. For example, if March crude futures are trading at $71, the March crude 71 puts and March crude 71 calls are both at-the-money.
Out-of-the-Money – If the option is out-of-the-money, the option’s strike price is higher (for calls) or lower (for puts) than the underlying price. For example, if March crude futures are trading at $71, the March crude 75 calls and 68 puts are both out-of-the money.
In-the-Money – If the option is in-the-money, the strike price is lower (for calls) or higher (for puts) than the underlying price. For example, if March crude is trading at $71, the March crude 78 puts and 70 calls are both in-the-money. In-the-money options have intrinsic value, because they could be exercised and the resulting futures position immediately offset in the futures market for profit.