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.*

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