HELPING FUTURES TRADERS SINCE 1997

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Introduction There are two basic types of options on futures, put options and call options. An option is a subset of the futures market and each option is option on futures pricing to a certain commodity and futures month for that commodity. Options are similar to insurance option on futures pricing several ways, including some of the related terminology. Options bought or sold through a commodity futures broker do not have a physical delivery commitment attached to them.

Some grain companies offer contracts that use options, although those handled by a grain company generally contain a physical delivery commitment. The purpose of this article is to provide an introduction to option on futures pricing on futures. There is much more information on options available through books and the internet.

The Basics - Puts An option on futures pricing is a choice. From a hedging point of view, buying a put option locks in a minimum futures price at a cost, the premium.

For example, a canola producer could buy a put option to protect against price downside from a certain price level. So, if the price of canola rose during the time that the put option was owned, the canola producer can still sell canola at the higher price.

Meanwhile, as the futures price rose, the value of the right to sell canola futures at the fixed option price level will drop, and the premium paid for that option may be lost.

This optional aspect of an option is an important difference from a sell futures position, option on futures pricing locks in a certain futures price. Another important distinction of buying an option compared to having a futures position is that the option premium paid plus commission is the maximum cost of guaranteeing a minimum price. There are no margin calls when you buy an option. Here is an example of a put option purchase using numbers from the ICE Canada canola market.

It is this right that gives the put option a value. The premium of the option will change as the futures price changes, as time passes, and option on futures pricing response to volatility in the underlying futures contract to which that option relates. From a hedging point of view, buying a call option locks in a maximum futures price. For example, a canola crusher could buy a call option to protect against price upside above a certain price level.

Another use of a call option is for replacement strategy. For example, a farmer delivers and prices some canola. Believing that the futures price will rise, the farmer buys call options on a similar quantity of canola to that sold physically. By doing so, he can benefit from a potential rise in the futures market, thus adding value to the option on futures pricing already sold. By using the call option purchase for this strategy, risk is limited to possible loss of the premium paid for that call option.

Meanwhile, he has the majority of the proceeds from the canola sale and has reduced risk of spoilage and theft on option on futures pricing quantity of canola sold. Here is an example of a call option purchase using numbers from the ICE Canada canola market. It is this right that gives the call option its value. You buy an option…then what? If you buy an option, there are three ways option on futures pricing deal with that option: You can exercise the option, that is, create the specific futures position that buying the option has given you the rights for.

When that is complete, you no longer own an option, but now have a new futures position. If you exercise a put option, you will create a sell futures position in your account; if you exercise a call option, you will create a buy futures position in your account.

The specific futures position created will be determined by the characteristics of the option that you owned. You can sell the option as an option for its premium, which might be greater or less than the premium when you purchased that option. This alternative is often the best choice. You can sell an option anytime that futures and options are trading.

You may be able to capture some option premium that would be lost when exercising the option option on futures pricing letting the option expire. Brokerage commissions to sell an option are usually less than when you exercise the option. If you hold the option until the end of its life, it may not have any remaining premium.

When the remaining option premium is less than the brokerage cost to sell that option, then you would just let the option expire.

Option on futures pricing insurance, in letting an option expire, you could consider that the option provided specific protection i. Option Premium There are two parts to an option premium … intrinsic and time option on futures pricing. Intrinsic value is what the option would be worth as a futures position if the option was exercised. Time value is sometimes referred to as risk premium. Two main factors affect time value, and they are time itself, and volatility of the underlying futures option on futures pricing.

Both of these factors are elements of risk. The longer the option life, the greater the risk to someone selling that option. The more volatile the underlying futures contract, the greater the risk to someone selling that option.

Note that, if an option is exercised, any remaining time value in that option is immediately extinguished. Until expiry of the option, there is usually some time value in option on futures pricing option, so it is better to capture some return of that time premium by selling the option rather than exercising it. The premium value of an option is subject to change by open market trading whenever the futures market is trading. On days when a particular option strike price does not trade, the commodity exchange uses a computer program to estimate the daily settlement value of that option.

Alternatively, if the futures price rises, the value of the put option will tend to fall. But, if the futures price rises, it implies that the value option on futures pricing physical canola is also rising. If the option is kept to expiry, and if then the option has intrinsic value i. That sell futures position would then have to be offset at some time before the March canola futures expires.

Delivery Commitment Flexibility Buying an option through a commodity futures broker leaves the basis portion of price open. That can be a good thing if basis levels for the expected delivery period are considered too weak to lock in, or if one does not want at the time to commit to a physical sale to a certain buyer.

The put option is an attractive alternative to crop producers who are concerned about committing to a delivery with the possibility of a crop shortfall on quantity or qualityto those option on futures pricing who have already forward contracted with physical buyers to their comfort level or to producers who wish to retain the ability to take advantage of possible higher prices. Summary A first step in planned marketing is to know your costs of production for a crop, and then use that information as a base for establishing profitable price targets as part of a marketing plan.

As a crop producer, using a put option can provide protection from a price drop while retaining flexibility to take advantage of a higher price and still shop for the best buyer in terms of basis and grade. For more information about the content of this document, contact Neil Blue. This document is maintained by Erminia Guercio. This information published to the web on November 15,

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United Futures Trading Company, Inc. Suite Chicago, IL What are known as put and call options are traded on most active futures contracts. The principal attraction of buying options is that they make it possible to speculate on increasing or decreasing futures prices with a known and limited risk. Options can be most easily understood when call options and put options are considered separately, because they are totally separate and distinct. Buying or selling a call in no way involves a put, and buying or selling a put in no way involves a call.

Buying Call Options The buyer of a call option acquires the right, but not the obligation, to purchase go long a particular futures contract at a specified price at any time during the life of the option. One reason for buying call options is to profit from an anticipated increase in the underlying futures price. A call option buyer will realize a net profit if, upon exercise, the underlying futures price is above the option exercise price by more than the premium paid for the option. Or a profit can be realized if, prior to expiration, the option rights can be sold for more than they cost.

You expect lower interest rates to result in higher bond prices interest rates and bond prices move inversely. To profit if you are right, you buy a June T-bond 90 call. As mentioned, the most that an option buyer can lose is the option premium plus transaction costs. In contrast, if you had an outright long position in the underlying futures contract your potential loss would be unlimited. It should be pointed out, however, that while an option buyer has a limited risk the loss of the option premium , his profit potential is reduced by the amount of the premium.

Although an option buyer cannot lose more than the premium paid for the option, he can lose the entire amount of the premium. This will be the case if an option held until expiration is not worthwhile to exercise. Buying Put Options Whereas a call option conveys the right to purchase go long a particular futures contract at a specified price, a put option conveys the right to sell go short a particular futures contract at a specified price.

Put options can be purchased to profit from an anticipated price decrease. As in the case of call options, the most that a put option buyer can lose, if he is wrong about the direction or timing of the price change, is the option premium plus transaction costs.

However, you could have lost the entire premium. How Option Premiums are Determined Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers.

Three major variables influence the premium for a given option:. Said another way, an option is an eroding asset; its time value declines as it approaches expiration. All else being equal, the greater the volatility the higher the option premium. In a volatile market, the option stands a greater chance of becoming profitable. Selling Options At this point, you might well ask, who sells the options that option buyers purchase?

The answer is that options are sold by other market participants known as option writers, or grantors. Their sole reason for writing options is to earn the premium paid by the option buyer. If the option expires without being exercised which is what the option writer hopes will happen , the writer retains the full amount of the premium.

It should be emphasized and clearly recognized, however, that unlike an option buyer who has a limited risk the loss of the option premium , the writer of an option has unlimited risk. Simply said, any profit realized by an option buyer represents a loss for the option seller. The foregoing is, at most, a brief and incomplete discussion of a complex topic. Options trading has its own vocabulary and its own arithmetic. If you wish to consider trading in options on futures contracts, you should discuss the possibility with your broker and read and thoroughly understand the risk disclosure statement which he is required to provide.

In addition, have your broker provide you with educational and other literature prepared by the exchanges on which options are traded. Or contact the exchange directly. A number of excellent publications are available, including Options on Futures Contracts: Past performance is not necessarily indicative of future results. The risk of loss exists in futures and options trading. Past performance is not necessarily indicative of future results and the risk of loss does exist in futures trading.

All trading rates quoted per side. Applicable exchange, regulatory, and brokerage fees apply to rates shown. Please email webmaster unitedfutures. Open An Account Now Online!

Options on Futures Contracts. This publication is the property of the National Futures Association. Return to table of contents What are known as put and call options are traded on most active futures contracts. A March Treasury bond 92 call option would convey the right to buy one March U.