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. Investing

    I Can't Believe It's Corn!

    The widespread use of corn spans from food additives to fuel, aspirin and windshield washer fluid. Find out where else it's used and the size of this growing industry.
  2. Trading

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
  3. Trading

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  4. Trading

    How to Trade Options on Government Bonds

    A look at trading options on debt instruments, like U.S. Treasury bonds and other government securities.
  5. Investing

    Corn Traders Are Bracing Themselves For More Selling

    Recently, the DBA fund started trading near a short-term level of support. This move sparked talks of a commodity reversal. Corn prices are suggesting this prediction is too early.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center