The Power of Options.
It is always important to understand what the financial instrument is before deciding to trade it. What is an option, specifically what is a call, what is a put? Who is the holder or buyer? And who is the writer or seller?
An option is a contract between two parties. The purchaser, also known as the holder, buyer, or owner, is long the position. The option buyer pays money for the right to buy or the right to sell a futures contract. Conversely, the seller, also known as the writer or grantor, is short the position. The option seller accepts money to take on an obligation. The option seller must buy or must sell a particular futures contract if ordered to do so (assigned) by the option buyer.
• The buyer of an option has acquired a right.
• The seller of an option has taken on an obligation.
• Calls and puts there are two types of futures options: calls and puts
• A futures call option conveys to the call buyer the right to buy the underlying futures contract at a set price (the strike price) until the option expires.
• A futures call option conveys to the call seller the obligation to sell the underlying futures contract at a set price (the strike price) until the option expire
• A futures put option conveys to the put buyer the right to sell (take a short position in) the underlying futures contract until the option expires
• A futures put option conveys to the put seller the obligation to buy the underlying futures contract until the option expires and if the put owner exercises his right.
A call option is the right to buy a futures contract at a set price within a set time. A put option is the right to sell a futures contract at a set price within a set time. The buyer of an option contract pays the seller a premium (money) to accept obligation under the contract.
During a specified (shorter) period prior to its expiration; typically from one to five business days, the option holder (a put or call buyer) has three choices. The holder may:
• Exercise the option (i.e., use it to purchase or sell the underlying futures contract);
• Let the option expire (i.e., the buyer forfeits the premium paid to the seller); or
• Sell the option contract before it expires.
Options Language
Before trading options, it is important to understand certain terminology relating to options:
• Call -the buyer has the right to buy a futures contract at a specified price for a limited time (until the contract expires):
• Call buyer -pays a premium (money) for the right to buy until expiration the underlying futures contract at the specified (strike/exercise) price.
• Call writer -receives a premium and takes on, until expiration, the obligation to sell the underlying futures contract at the specified price if the call buyer exercises the option covered –position of an option writer (seller ) who owns the underlying asset and can guarantee delivery if the option contract is exercised.
• Expiration date -the specified date on which the option either is exercised or becomes worthless and the buyer no longer has rights under the contract.
• Naked (or uncovered) - position of an options investor who writes call or a put on a futures contract and does not own the underlying asset.
• Option- contract giving the buyer the right to buy or sell a futures contract and requiring the writes to sell or buy the underlying futures contract if the option buyer exercises the right granted under the contract.
• Put -the buyer has the right to sell a futures contract at a specified price until expiration.
• Put buyer - pays a premium (money) for the right to sell the underlying futures contract at the specified price until expiration.
• Put writer - receives a premium and takes on, for a specified time, the obligation to buy the underlying futures contract at the specified price if the put buyer exercises the option.
• Strike price -(or exercise price) the price at which the underlying futures contract will be transferred if the option buyer exercises the contract regardless of the current market price.
• Premium - money the option buyer pays (for acquiring a right) to the option writer (for accepting an obligation). The amount of the premium is not standardized in the contract .rather, it is determined by the market –an amount buyer will pay and sellers will accept.
• Underlying futures contract - futures contract bought or sold when an option is exercised or on which an options is based.
Speculation/leverage opportunities
For traders with a high level of risk tolerance, options provide ample opportunity to use relatively moderate sums of money to leverage sizable positions. Investors can buy calls giving them the right, but not the obligation, to buy the financial instrument at a specific price (strike). However, options may expire worthless and an options buyer risks the entire amount paid plus any commissions paid.