Options - Option Theory

Option Theory
An "option" is a contract that grants its owner the right, but not the obligation, to make a transaction in an underlying commodity or security, at a certain price within a set time in the future. As with a futures contract, the underlying commodity or security could be anything. The key difference between an option and a future is that a future requires the party with the long position to deliver and the party with the short position to take delivery, if these positions remain open at the expiration date. The holder of an option – which can be the right to either buy or sell – can simply let the option expire if exercising it would be against his interests. With options, the obligation rests with the seller (writer).

Envision a scenario where corn would appear to be undervalued to the trader. It trades at $20/bushel and he or she thinks it is worth at least double that. As with the futures market, one could always buy the underlying commodity today on the spot market, hold it until the price doubles and then sell it. That would be the easy, but not the most efficient way, in terms of time or return on investment, even if corn were not perishable and even if storage costs were nominal. Instead, the trader decides that the price is not going to move until Department of Agriculture forecasts are released 60 days from now. In the meantime, there are other trades to make and the trader does not want incur opportunity costs for two months, when he could otherwise be investing.

Instead, he purchases an option that gives him the right, but not the obligation to buy 10,000 bushels of corn in 60 days at $25. This option costs far less than the underlying commodity, so he still has money to pursue other transactions. Suppose the 60 days elapse and the Agriculture Department comes out and surprises everyone - except you - with news of a shortfall in corn supply. The commodity, which had been trading in the $20 to $25 range for months, exceeds $30/bushel and approaches the target price of $40. While other investors are buying corn at $30, $32 or $38 a share, the trader has the option to buy it at $25/bushel. That means whoever sold (wrote) the option is now obligated to purchase the corn at the market price (unless he or she has covered the call with an inventory of corn), but sell it to the option buyer at $25. The trader exercises the option, purchases the 10,000 bushels at $25 and then sells them immediately for almost $40 each.

As with futures, agricultural products are but one of numerous types of underlying assets that include, to wit:

  • fixed-income securities,
  • currencies,
  • livestock,
  • common stock,
  • stock indexes,
  • interest rates, and
  • extracted commodities (e.g. oil, metals).

*With options on a futures contract, the futures contract is the underlying or the actual. It, in turn, is a derivative with its own underlying product.*

Calls And Puts
Related Articles
  1. Stock Analysis

    Glencore Vs. Noble Group

    Read about the differences between Glencore and Noble Group, two companies in the commodities business. Learn about accounting accusations facing Noble Group.
  2. Chart Advisor

    Watch This ETF For Signs Of A Reversal (BCX)

    Trying to determine if the commodity markets are ready for a bounce? Take a look at the analysis of this ETF to find out if now is the time to buy.
  3. Investing Basics

    The Importance of Commodity Pricing in Understanding Inflation

    Commodity prices are believed to be a leading indicator of inflation, but does it always hold?
  4. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  5. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  6. Fundamental Analysis

    Performance Review: Commodities in 2015

    Learn how commodities took a big hit in 2015 with a huge variance in performances. Discover how the major commodities performed over the year.
  7. Stock Analysis

    The Biggest Risks of Investing in SandRidge Stock

    Learn about the significant risks of investing in SandRidge. Read how the company may not be able to service its substantial debt load.
  8. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  9. Chart Advisor

    These 3 ETFs Suggest Commodities Are Headed Lower (COMT,CCX,DBC)

    The charts of these three exchange traded funds suggest that commodities are stuck in a downtrend and it doesn't look like it will reverse any time soon.
  10. Fundamental Analysis

    The Changing Economics of the Oil Business

    Read about the changing economics of the oil business. Discover how oil companies are using technology to increase the efficiency of old wells.
RELATED TERMS
  1. Nonrenewable Resource

    A resource of economic value that cannot be readily replaced ...
  2. Warrant

    A derivative that confers the right, but not the obligation, ...
  3. Swap

    A derivative contract through which two parties exchange financial ...
  4. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  5. Convergence

    The movement of the price of a futures contract towards the spot ...
  6. Crude Oil

    Crude oil is a naturally occurring, unrefined petroleum product ...
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  3. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  4. Is a financial advisor required to have a degree?

    Financial advisors are not required to have university degrees. However, they are required to pass certain exams administered ... Read Full Answer >>
  5. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  6. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
Hot Definitions
  1. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  2. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  3. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  4. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  5. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
Trading Center