Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called the premium, for some amount of time, let’s say a year. The policy has a face value and gives the insurance holder protection in the event the home is damaged.
Fluctuations in option prices can be explained by intrinsic value and extrinsic value, which is also known as time value. An option's premium is the combination of its intrinsic value and time value. Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the amount above the strike price that the stock is trading. Time value represents the added value an investor has to pay for an option above the intrinsic value. This is the extrinsic value or time value. So, the price of the option in our example can be thought of as the following:
The contract specifications are specified for one contract, so the tick value shown above is the tick value per contract. If a trade is made with more than one contract, then the tick value is increased accordingly. For example, a trade made on the ZG options market with three contracts would have an equivalent tick value of 3 X $10 = $30, which would mean that for every 0.1 change in price, the trade's profit or loss would change by $30.
The world of commodity options is diverse and cannot be given justice in a short article such as this. The purpose of this writing is to simply introduce the topic of options on futures. Should you want to learn commodity options trading strategies in more detail, please consider purchasing "Commodity Options" published by FT Press at www.CommodityOptionstheBook.com.
When buying a call option, the strike price of an option for a stock, for example, will be determined based on the current price of that stock. For example, if a share of a given stock (like Amazon (AMZN) ) is $1,748, any strike price (price of the call option) that is above that share price is considered to be "out of the money." Conversely, if the strike price is under the current share price of the stock, it's considered "in the money."
Still other traders can make the mistake of thinking that cheaper is better. For options, this isn't necessarily true. The cheaper an option's premium is, the more "out of the money" the option typically is, which can be a riskier investment with less profit potential if it goes wrong. Buying "out of the money" call or put options means you want the underlying security to drastically change in value, which isn't always predictable.
As shown above, a long options trade has unlimited profit potential, and limited risk, but a short options trade has limited profit potential and unlimited risk. However, this is not a complete risk analysis, and in reality, short options trades have no more risk than individual stock trades (and actually have less risk than buy and hold stock trades).
As an example, let's say a farmer is expecting to produce 1,000,000 bushels of soybeans in the next 12 months. Typically, soybean futures contracts include the quantity of 5,000 bushels. The farmer's break-even point on a bushel of soybeans is $10 per bushel meaning $10 is the minimum price needed to cover the costs of producing the soybeans. The farmer sees that a one-year futures contract for soybeans is currently priced at $15 per bushel.
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Equity options today are hailed as one of the most successful financial products to be introduced in modern times. Options have proven to be superior and prudent investment tools offering you, the investor, flexibility, diversification and control in protecting your portfolio or in generating additional investment income. We hope you'll find this to be a helpful guide for learning how to trade options.
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Options on futures contracts are exactly what the name implies, they give traders "options". They are capable of being used in nearly every commodity market scenario and with variable risk and reward profiles. Too many traders fail to tap the true potential and flexibility of option spreads due to their seemingly complex nature; however, things aren't always as they appear. We strongly believe that you owe it to yourself to overcome your fear of trading commodity options and open your mind to the possibilities.
The potential home buyer would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at say $400,000 at any point in the next three years. Well, they can—you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant such an option for free. The potential home buyer needs to contribute a down-payment to lock in that right.
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. Speculating with a call option—instead of buying the stock outright—is attractive to some traders since options provide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared to the full price of a $100 stock.
You also can limit your exposure to risk on stock positions you already have. Let’s say you own stock in a company but are worried about short-term volatility wiping out your investment gains. To hedge against losses, you can buy a “put” option that gives you the right to sell a particular number of shares at a predetermined price. If the share price does indeed tank, the option limits your losses, and the gains from selling help offset some of the financial hurt.
• Put Options – Give the buyer the right, but not the obligation, to sell the underlying at the stated strike price within a specific period of time. The seller of a put option is obligated to deliver a short position from the strike price (accept a long futures position) in the case that the buyer chooses to exercise the option. Keep in mind that delivering a short futures contract simply means being long from the strike price.
For example, if you bought a long call option (remember, a call option is a contract that gives you the right to buy shares later on) for 100 shares of Microsoft stock at $110 per share for December 1, you would have the right to buy 100 shares of that stock at $110 per share regardless of if the stock price changed or not by December 1. For this long call option, you would be expecting the price of Microsoft to increase, thereby letting you reap the profits when you are able to buy it at a cheaper cost than its market value. However, if you decide not to exercise that right to buy the shares, you would only be losing the premium you paid for the option since you aren't obligated to buy any shares.