What is an option and how does it work in the commodity derivatives market? Here is all you need to know about options.
An option is a contract that conveys the right, but not the obligation, to buy or sell a particular item at a certain price for a limited time. Only the seller of the option is obligated to perform.
An option gives the right but not the obligation to buy (call option) or sell (put option) an underlying commodity or financial instrument at a specified price (exercise price or strike price) by or at a certain date in the future.
In the context of commodity options, the underlying instrument is usually the commodity future. It is therefore a derivative of a derivative. Options on commodity futures can be thought of like insurance.
An option buyer (the insured) pays a premium to an option seller (the insurance company) for the right to buy or sell a futures contract at a specific price. However, just like with insurance, the option buyer may or may not exercise his right (use his insurance).
Options on futures are different from futures themselves in the sense that the most a buyer can lose is the cost of purchasing the option, known as the premium, along with transaction costs. An option seller, however, has unlimited risk. In the insurance example used earlier, the option buyer is like the insured and is paying only the insurance premium for his protection.
The option seller is like the insurance company and is taking on unlimited risk in the hope that he can collect the premium and the insurance will not be used.
Option Buyer: The purchaser of either a call or put option. Option buyers receive the right, but not the obligation, to assume a futures position. Also referred to as the holder.
Option Premium: The price of an option the sum of money that the option buyer pays and the option seller receives for the rights granted by the option.
Option Seller: The person who sells an option in return for a premium and is obligated to perform when the holder exercises his right under the option contract. Also referred to as the writer.
Option Spread: The simultaneous purchase and sale of one or more options contracts, futures, and/or cash positions.
Option Writer: See Option Seller
