Options contracts
An option on a commodity futures contract gives the buyer, who pays a market determined price known as a "premium," the right (but not the obligation), within a specific time period, to exercise his or her option. Exercise of the option will result in the person being deemed to have entered into a futures contract at a specified price known as the "strike price." In some cases, an option may confer the right to buy or sell the underlying asset directly, and these options are known as options on the physical asset.
Stating it simply, an option is nothing more than an agreement between two people to buy or sell something at a fixed price on a fixed date. People use options contracts to buy and sell all sorts of things. Some people use them to buy and sell real estate even.
Exchange traded futures and options provide several important economic benefits, including the ability to shift or otherwise manage the price risk of cash market or tangible positions. In open markets, where large numbers of potential buyers and sellers compete for best prices, futures markets effectively establish competitive prices. This is because these markets provide the opportunity for leveraged investments and attract large pools of risk capital. As a result, futures markets are among the most liquid of all global financial markets, providing low transaction costs and ease of entry and exit. This, in turn, gives business a way to manage the price risks. And the savings resulting from effective risk management can be passed on to the final consumers of the commodities, currencies and financial instruments that underlie the futures and options contracts.
Advantages of Options Contracts
- No margin calls.
- Ability to take advantage of favorable price moves.
- Limited risk. The maximum potential loss is known when the option is purchased.
Disadvantages of Options Contracts
- Must pay a premium.
- Because of the "price insurance" (premium) associated with options, they may yield a lesser return than other marketing alternatives in certain market situations. If an option is exercised, a futures position, with all it's financial and contract obligations, is assumed.
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