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Futures and Options Q & A | PFG Futures

5. What are Options?

In 1982, a market innovation was introduced to the futures exchanges. Options on Futures were instituted. In contrast to futures, Options on Futures allow investors and risk managers to define risk and limit it to the cost of the premium paid for the right to buy or sell a futures contract, plus the commissions and fees. At the same time, options can provide the buyer with unlimited profit potential.

Mainly because they have a known and limited risk, buying options on futures contracts have become an attractive investment for many individuals seeking to profit from significant price movements – either upward or downward – in today’s increasingly volatile and often uncertain investment environment.

6. What is an Option Contract?

There are two types of options: “calls” and “puts.” A call gives the holder of the option the right, but not the obligation, to buy the underlying futures contract. Conversely, a put option gives the holder the right, but not the obligation, to sell the underlying futures contract.

There is regulated exchange trading in numerous call options and put options. Which one to invest in depends entirely on your price expectations? That is, on whether you expect the price of a particular commodity to go up, or whether you expect it to go down.

CALL OPTION

PURCHASING A CALL GIVES YOU A SPECIFIC LOCKED-IN PRICE AT WHICH POINT YOU HAVE THE RIGHT, BUT NOT THE OBLIGATION, TO BUY A FUTURES CONTRACT ON A COMMODITY THAT YOU EXPECT TO INCREASE IN VALUE. THUS, IF YOU LOOK FOR, SAY, THE PRICE OF GOLD TO GO UP, YOU’D BUY A GOLD CALL OPTION.

PUT OPTION

PURCHASING A PUT GIVES YOU A SPECIFIC LOCKED-IN PRICE AT WHICH POINT YOU HAVE THE RIGHT, BUT NOT THE OBLIGATION, TO SELL A FUTURES CONTRACT ON A COMMODITY THAT YOU EXPECT TO DECREASE IN VALUE. THUS, IF YOU LOOK FOR, SAY, THE PRICE OF GOLD TO GO DOWN, YOU’D BUY A GOLD PUT OPTION.

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An easy way to remember which option does what is to think of the terms “call up” and “put down.” A “call” is a way to profit if prices go up. A “put” is a way to profit if prices go down.

7. Besides Calls and Puts, what other terms should I become familiar with?

Just a couple more terms. You should know what is meant by an option’s “premium” and also by an option’s “strike price.”

PREMIUM

USED IN CONNECTION WITH OPTIONS, THE PREMIUM HAS THE SAME MEANING AS WHEN USED IN CONNECTION WITH INSURANCE. IT’S THE PRICE THAT YOU PAY TO BUY A GIVEN OPTION.

STRIKE PRICE

THIS IS THE SPECIFIC DOLLARS AND CENTS PRICE AT WHICH THE OPTION GIVES YOU THE RIGHT TO BUY A PARTICULAR COMMODITY, IN THE CASE OF A CALL, OR TO SELL THE COMMODITY IN THE CASE OF A PUT. THE STRIKE PRICE IS STATED IN THE OPTION.

PURCHASING OPTIONS*

vs.

FUTURES CONTRACTS

Questions

Futures Options

Can I profit from either a rising or declining market? YES YES
Can I ever be subject to margin calls? YES NO
Can I be forced to liquidate a market position? YES NO
Can I be required to make or take delivery? YES NO
Is it possible to lose more than my initial investment? YES NO
Is my risk unlimited? YES NO
Is my profit potential limited? NO NO

*This comparison applies only to the purchase of options. The writing (selling) of options involves significantly different and generally greater risk. We do not recommend option writing for beginning investors, except in connection with certain limited risk strategies.

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