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Mechanics of How Options on Futures Work

You have to walk before you can run. Similarly, you have to understand basic mechanics of how options on futures work before you can effectively use options as risk management tools in the farm business.

An option conveys the right to buy or sell a futures contract. When you buy an option you acquire the right, but not the obligation, to buy or sell a futures contract.

When you sell (write) an option you take on the obligation to take the opposite side of the futures position the option buyer has the right to take. For example, if you sell an option giving someone to right to buy futures you must sell futures to the option buyer should the option buyer choose to exercise the option. 

Option contracts trade in a similar manner as their underlying futures contracts.

Types of options

If you buy an option to buy futures, you own a call option. If you buy an option to sell futures, you own a put option.

Call and put options are separate and distinct options.

Calls and puts are not opposite sides of the same transaction.

Strike price

When you buy or sell an option, you must choose from a set of predetermined price levels at which you'll enter the futures market if the option is exercised. These are called strike prices. For example, if you choose a cotton option with a strike price of 75 cents per pound, upon exercising the option you will buy or sell futures for 75 cents. You'll enter the futures market at 75 cents regardless of the current level of futures price.

Strike prices are listed in predetermined price levels for each commodity: each cent per pound for cotton, every 25 cents a bushel for soybeans and 10 cents for corn.

When trading is initiated on an option, separate options will be offered with strike prices below, roughly equal to, and above the current futures price.

Delivery month

When buying an option you must choose which delivery month you want. Options have the same delivery months as the underlying futures contracts. For example, cotton options have March, May, July, October and December, delivery months, the same as cotton futures.

If you exercise a December cotton put op­tion you will sell December futures. If you exercise a December cotton call op­tion you will buy December futures.

Closing-out your option

You can close out an option position in three ways:

• Exercise it into a futures position
• Sell it back into the options market
• Let it expire worthless

Exercise

Exercising an option converts the option into a futures position at the strike price. Only the option buyer can exercise an option. When you exercise a call option that you own, you buy futures at the strike price. An option writer (seller) must take the opposite side (sell) of your futures position at the strike price.

When you exercise a put option that you own, you sell futures at the strike price. An option writer (seller) must take the opposite side (buy) of your futures position.

Because an option seller is obligated to take a fu­tures position should the option buyer choose to exercise, the option seller must post margin money to cover the position he might get exercised into. The option seller also faces the possibility of margin calls.

Option buyers pay the premium and whatever trading costs they face.

Offsetting transaction

If you have already purchased an option, you can offset your position by selling another option with the same strike price and delivery month. Taking an offsetting position gets you out of the options market.

Amount of your gain or loss from the transaction depends on the premium you paid when you purchased the option and the premi­um you received when you sold the option, less the transaction cost. The most money option buyers will feed into the market is their initial premium plus trading costs.

If you have written (sold) an option, you can offset this position by buying an option with the same strike price and delivery month. You are now out of the options market. The amount of gain or loss from the transaction depends on the premium you received when you sold the option and the premium you paid when you repurchased the option, less transaction costs.

Avoid this mistake

Suppose you've bought an option. You want out of the market. Unfortunately the option you tell your broker to sell does not have the same strike price and/or delivery month as the option you originally purchased. You'll end up with two positions in the market; one as a buyer and another as a seller.

Expire

An option expires if it is not exercised within the time period allowed. The expiration date is the last day on which the option can be exercised. Options expire in the month prior to contract delivery. For example, a July corn option expires in June.