INTRO TO OPTIONS Options are much like futures, with one important difference: An option gives its owner the right, but not the obligation, to buy or sell a specific item at a specific price (the “strike price”) over a specific span of time. The owner can choose when to exercise an option, or he or she can choose not to exercise the option at all. The option then expires worthless, and the investor’s only loss is what he or she paid for the option. Thus, options have less downside risk than futures.
A call option gives you the right (but not the obligation) to buy an underlying contract at a specified price; you would buy calls if you think the underlying contract’s price will rise. A call option is in the money if the price of the underlying contract is above the strike price.
A put option gives you the right (but not the obligation) to sell an underlying contract at a specified price; you would buy puts if you think the underlying contract’s price will go down. A put option is in the money if the price of the underlying contract underlying the option is below the strike price.
The term “right” refers to one of the primary differences between futures and options. In futures, an obligation is created for both the buyer and seller. The buyer must take, and the seller must make, delivery unless the position is offset prior to delivery. In the case of options, unilateral obligation is placed on the “writer” or seller of the options, that is, only the option writer is obligated to perform.
The buyer of the option may exercise the option, but may also decide to abandon it and let the option expire. In the event the option is exercised, the option writer must deliver the underlying futures position. Once the writer has received notice from the buyer that the option will be exercised, the writer cannot offset his option position.
The price paid for a call or put option is called the premium, which is established in open, competitive trading at one of the major exchanges trading options.
In return for assuming the obligation, the writer of the option receives payment of a premium from the buyer. The premium is paid in full, in cash, when the option is purchased. The buyer is paying for the specific rights. The seller agrees to grant those rights and is paid for assuming the risks of offering options. To the writer, the premium is the maximum profit available in a trade.
The two basic components of premium are intrinsic value and time value, where
Premium = Intrinsic Value + Time Value
The intrinsic value is the amount an option would be worth if it were to expire immediately. The intrinsic value of a call option declines to zero when the price of the underlying futures contract falls to the strike price or below. For the put option, the intrinsic value will decline to zero when the price of the underlying futures contract rises above the strike prices.
A call option with a strike price less than the market price is said to be “in-the-money”. A put option is “in-the-money” when a strike price is above the market price.
A call option with a strike price above the current market price is said to be ““out-of-the-money”. When the strike price of a put option is below the current market price, it is also “out-of-the-money”.
When the strike price of an option, put or call, is exactly at the current market price, it is said to be “at-the-money”.
The second component that makes up the option premium is time value. It is based entirely on the future expectations of price movements. In general, the more time until expiration, the greater the time value.
Calls and puts may not be as risky as futures — because you’re not obligated to do anything, your greatest loss will be the loss of the cost of the call or put. But options are leveraged on the upside. For example, buying call options requires far less money than the margin requirements of buying the futures contract would.
Perhaps the most salient difference between options and futures is staying power or the ability to withstand adverse market moves. With futures, both the buyer’s and the seller’s risk is theoretically unlimited, and each party is in jeopardy of the market moving against the position. Options, on the other hand, possess a mechanism of defined risk. The premium paid represents the total amount the buyer has at risk. If he forfeits the premium, he has no further financial obligation. Due to this unique situation, the buyer is not required to provide margin or face the potential of margin calls regardless of where the underlying futures prices moves during the life of the option. No matter how far the trade moves against the position, the buyer can hold the option in anticipation of an eventual turn around in the market that will make his position profitable.
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