Review of Futures
Futures contracts are legally binding agreements, made at a futures exchange, to buy or sell something at a specific time in the future — hence the name. That something could be an agricultural commodity such as live cattle, a financial commodity such as foreign currencies or Eurodollars, or an index such as the S&P 500. Each contract specifies the quantity (for example, 40,000 pounds of live cattle or 62,500 British pounds) of a commodity and the time of delivery (such as October CME Live Cattle or September CME British pound futures).

Options
To provide additional financial flexibility to the investment community, CME also offers trading on another type of exchange-traded derivative contract — options on futures. These contracts offer the buyer the right, but not the obligation, to buy or sell an underlying futures contract at a particular price.

In futures trading, the risks can be higher than some speculators can bear. Losses can be large. With options, though, you can limit this risk substantially. If you didn’t want to commit yourself to buying (long) a futures contract, or selling (short) a futures contract, you could buy an option on a futures contract.

You would then have the right, but not the obligation, to exercise the option and buy or sell the futures contract at a specified price if it seemed profitable. You could also simply offset, or sell the option back in the market, if it had increased in value. On the other hand, if the option became less valuable as the market moved against the position you’ve taken, you could simply forget it, let it expire and write off the money that you paid for it. This concept is the same as paying the insurance premium on your car. If nothing goes wrong, you simply write off the money you spent on insurance.

Calls and Puts
An option to buy a futures contract is known as a call option. People who buy calls are forecasting that the price of the underlying futures is going to go up, so they can buy low and sell high. An option to sell a futures contract is known as a put option. People buying puts are betting that the price of the underlying futures is going to go down, enabling them to sell high and buy low. Of course, if the market moves against their position, option holders can let the options expire.

Now here’s where it can get confusing. You can be an option buyer who buys a put or a call. Or you can be an option seller (also called the option writer) who sells a put or a call. In other words, you can buy the right to buy or sell the underlying futures contract or you can sell the right to buy or sell the underlying futures contract. The table below helps you
sort it out.

Premium
The premium is the cost of an option, the price the buyer pays to the seller in exchange for the option. This premium rises and falls as the traders make their bids and offers. The option buyer has no risk beyond the payment of the premium. The buyer’s maximum dollar risk is therefore limited to the amount of the premium plus the commission paid to the brokerage firm. (The option seller’s risks are different and considerably larger.)

Strike Price
An option’s strike price (also called the exercise price) is the price at which you go Long (in the case of a Call) or go Short (in the case of a Put) the underlying futures contract. For example, the buyer of a CME Swiss franc June 71 call option has the right to buy (or go Long) an underlying June CME Swiss franc futures contract at 71¢/SF anytime on or before the option’s expiration date. The holder of an October CME Live Cattle 69
put option has the right to sell (go Short) an October CME Live Cattle futures contract at 69¢/pound on or before the expiration of the option.
Several puts or calls at different strike prices will be available for a particular underlying futures contract. For example, there may be December CME S&P 500 put options at strike prices of 1210, 1220, 1230, and and so (x $250).

SELL PUT
Profit: Limited
Loss: Unlimited
Seller: Guaranteed premium regardless of
price movement. Must deliver if option exercised
(if futures price is less than strike price).

BUY PUT
Profit: Limited
Loss: Unlimited
Buyer: Guaranteed loss of premium.
Profit depends of whether strike price
exceeds futures price and by how much.

SELL CALL
Profit: Limited
Loss: Unlimited
Seller: Guaranteed premium regardless of
price movement. Must deliver if option is
exercised (if futures price exceeds strike price).

BUY CALL
Profit: Limited
Loss: Unlimited
Buyer: Guaranteed loss of premium.
Profit depends on whether futures price
exceeds strike price and by how much.

Expiration
The expiration date of an option is the last day the option can be exercised or offset. Options have various expiration months, such as a June CME Swiss franc call or September CME Japanese yen put.

Exercise
As a call option buyer, you may exchange your option to buy a futures contract by a process known as exercise. If you exercise your call option, you will receive a long futures position at the strike price of the option. Likewise, if you exercise a put option, you will receive a short futures position at the strike price of the option.

A June CME Swiss franc 82 call could be exercised into a long June CME Swiss franc futures contract at a price of 82 ($.82 per franc), no matter what the current futures price may be. If you exercise a put option, you will be selling or going short the underlying futures at the option’s strike price. A CME Live Cattle June 70 put, if exercised, will result in a short futures position at 70¢/pound, no matter what the futures price is.

Offset
Rather than exercise, you may offset your long option position by selling it in the market, in the hope of making a profit. Remember that if you have bought a call option, you must sell a call option to offset. If you have bought a put option, you must then sell a put option to offset. You also may offset your option to limit losses on an unprofitable trade. For example, if you bought an option at a certain price and you see that it is losing value, you can sell the option back into the market in the hope of limiting your loss.

Time Decay
While some financial instruments can be held for many years or even indefinitely, options have a finite life span, usually no longer than nine months. Thus, if the underlying futures contract does not move as expected, the option holder will suffer because he has time working against him. Options are a wasting asset. That is, they will eventually be worth nothing by expiration if the futures contract fails to advance (in the case of call options) or decline (in the case of put options).

Stock Trading References:

Market Club Trading Service
Day Trading Advice
fundamental analysis
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Trading Philosophies
How to price options
Rockwell Trading Review
Swing Trading Defined
Options University Trading Tutorials
Options Trading Tutorials
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