Options on Futures : The Basics

An option is a contract which bestows the right to buy or sell a commodity at a predetermined price before an expiration date. Unlike holders of futures contracts, traders that hold options on futures are not under any obligation to trade the commodity.

A system like this seems vulnerable to defaults and trader disadvantage; the very things that standardised futures aim to abolish. However, in the case of options, sellers will collect premium from buyers to ensure they are not financially hurt in the event of a default occurring. If the trade carries through before the contract’s expiry, a seller is obliged to sell his commodity to the buyer.

Another key difference between the two is that while futures can only be traded on exchanges, options can be traded over-the-counter (OTC), for example, by large companies.

A Call option gives one the right to buy an asset while a put option grants the right to sell an asset. Call options should be bought if trader believes the value of a futures is going to rise. The opposite holds true for put options – they should be bought if a trader thinks the underlying futures value will decrease.

Those that buy options take the long position and are called holders. Traders that sell options take the short position and are known as writers.

Strike Price & Premiums

The price of the underlying futures at the time a put or call option is bought is known as the strike price or exercise price. If an asset such as butter came with a high strike price, this would mean that its call options would be cheaper (lower premium) and its put options would be dearer (higher premium).

The cost of a premium does not depend on strike price alone. It is also affected by the time left until contract expiry and the volatility of the underlying asset. The time premium of an option corrodes very quickly during the last month of contract. This is why traders like obtaining puts or calls with at least a month left; or else more often than not they end up making a loss.