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. Mutual Funds & ETFs

    ETF Analysis: United States Gasoline Fund

    Learn about the United States Gasoline Fund, the characteristics of the exchange-traded fund, and the suitability and recommendations of it.
  2. Mutual Funds & ETFs

    ETF Analysis: United States 12 Month Oil

    Find out more information about the United States 12 Month Oil ETF, and explore detailed analysis of the characteristics, suitability and recommendations of it.
  3. Investing Basics

    What is the Theory of Backwardation?

    Backwardation occurs when the futures price of a commodity is lower than its market price today.
  4. Mutual Funds & ETFs

    ETF Analysis: U.S 12 Month Natural Gas

    Learn about the United States 12 Month Natural Gas Fund, an exchange-traded fund that invests in 12-month futures contracts for natural gas.
  5. Options & Futures

    Analyzing The 5 Most Liquid Commodity Futures

    Crude oil leads the pack as the most liquid commodity futures market, followed by corn and natural gas.
  6. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB Commodity Tracking

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  7. Personal Finance

    Does It Make Sense to Go to College in Europe?

    If you're deciding whether to get a degree abroad, first do your research and talk to alumni who have completed the same program.
  8. Investing Basics

    Understanding the Spot Market

    A spot market is a market where a commodity or security is bought or sold and then delivered immediately.
  9. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  10. Chart Advisor

    Traders Step Back to Assess Commodities Damage

    Traders are turning to these exchange-traded notes and exchange-traded funds to analyze key commodities and determine what could be coming next.
RELATED TERMS
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Derivative

    A security with a price that is dependent upon or derived from ...
  4. Series 6

    A securities license entitling the holder to register as a limited ...
  5. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  6. Best To Deliver

    The security that is delivered by the short position holder in ...
RELATED FAQS
  1. 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 >>
  2. Can I use my 401(k) to pay for my college loans?

    If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>
  3. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  4. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
  5. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  6. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!