Options on Futures
An option on a futures contract gives its buyer the right, but not the obligation, to establish a futures position at a set strike price. This chapter covers calls and puts, premiums, and the risk profiles that make options a flexible tool for speculators and hedgers alike.
Calls and Puts
A call option gives the buyer the right to go long (buy) the underlying futures at the strike price; a put option gives the buyer the right to go short (sell) at the strike price. The buyer pays a premium for this right. The seller (writer) receives the premium and takes on the obligation to take the opposite futures position if the option is exercised. Buyers are bullish on calls and bearish on puts; writers hold the opposite view or seek premium income.
Premium, Intrinsic Value, and Time Value
The premium has two parts. Intrinsic value is the amount by which an option is in the money: a call is in the money when the futures price is above the strike; a put is in the money when the futures price is below the strike. Time value is the rest of the premium, reflecting the chance the option gains value before expiration. Time value erodes as expiration nears. An out-of-the-money option has no intrinsic value.
Risk and Reward Profiles
An option buyer's maximum loss is limited to the premium paid, while the potential gain can be large. An uncovered option writer keeps the premium at best but faces substantial risk if the market moves against the position. Because losses on futures themselves are open-ended, buying options is a common way for hedgers to cap cost while retaining upside, and for speculators to define risk in advance.