In 1982 the futures markets started trading options. The appeal of trading options as opposed to futures is the potential to increase profit — often substantially — while limiting risk.
What is an option on a future? An option gives the buyer the right but does not obligate him to buy or sell a particular futures contract at a set price at any time prior to a specific date. When the option is exercised, it is the actual futures contract that is delivered to settle the transaction, not cash.
How are options and futures different? While often confused, there are distinct differences between these two financial instruments. When purchasing an option, the buyer is purchasing the opportunity to buy or sell a futures contract by a certain date. To acquire the option, the buyer pays an up-front fee (called the premium). He can choose not to exercise his option and, therefore, accepts no risk. All risk resides with the writer of the option who is obligated to the sale or purchase if the buyer chooses to exercise his option. With futures, the contract binds both sides equally. Both buyer and seller share the risk and both make a good-faith deposit (called margin) to guarantee that they will meet their financial obligation. The buyer must buy and the seller must sell at the agreed price on the agreed date.
There are two types of futures options:
- Call options: The buyer of a call option buys the right but is not obligated to buy a particular futures contract at a set price at any time before the option expires.
- Put options: The buyer of a put option has the right but is not obligated to sell a particular futures contract at a set price at any time before the option expires.
In trading options on the futures market, futures traders need to be aware of and understand the relationships between:
- the futures contract and the commodity, security or index being traded and
- the relationship between the option and the futures contract.
It is this last point that makes trading in futures options both complicated and volatile. While there is tremendous potential for profit and risk is limited to the up-front cost, traders unfamiliar with options can quickly run amuck. Success is in large part dependent on the trader’s ability to accurately anticipate future price levels, a combination of experience, skill and feeling for the markets.
About Bill
