An option is the right, but not the obligation, to buy or sell a futures contract. The buyer of an option acquires this right. The option seller (writer) must take the opposite side of the option buyer's futures position. For example, if you buy an option with the right to buy futures, the option seller (writer) must sell futures to you if you exercise the option.
Option contracts are traded in a similar manner as their underlying futures contracts. All buying and selling occurs by open outcry of competitive bids and offers in the trading pit.
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.
When buying or selling an option, you must choose from a set of predetermined price levels at which you will enter the futures market if the option is exercised. These are called strike prices. For example, if you choose a soybean option with a strike price of $9 per bushel, upon exercising the option you will buy or sell futures for $9. This will occur regardless of the current level of futures price.
Strike prices are listed in predetermined price levels for each commodity: every 25 cents for soybeans, and 10 cents for corn.
The amount paid for an option is the premium. The option buyer pays the premium to the option writer (seller) at the time of the option transaction. The premium is the only part of the option contract that is negotiated. All other contract terms are predetermined. The premium is the maximum amount the option buyer can lose and the maximum amount the option seller can make.
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, corn options have December, March, May, July, and September delivery months, the same as corn futures. If you exercise a December corn option you will buy or sell December futures.
Closing-out your option
There are three ways you can close out an option position. The option can be exercised, it can be sold, or the option can be allowed to expire.
Exercising an option converts the option into a futures position at the strike price. Only the option buyer can exercise an option. When a call option is exercised, the option buyer buys futures at the strike price. The option writer (seller) takes the opposite side (sell) of the futures position at the strike price.
When a put option is exercised, the option buyer sells futures at the strike price. The option writer (seller) takes the opposite side (buy) of the futures position. Because of the option seller's obligation to take a futures position if the option is exercised, he/she must post margin money and is faced with the possibility of margin calls.
If you have already purchased an option, you can offset this position by selling another 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 paid when you purchased the option and the premium you received when you sold the option, less the transaction cost.
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 November soybean option expires in October.