Part Three: The Mechanics of Buying and Writing Options
Source: National Futures Association; published here with permission. This publication, Buying Options on Futures Contracts: A Guide to Uses and Risks,
is the property of the National Futures Association.
After you buy an Option, What Then?
At any time prior to the expiration of an option you can:
- Offset the option
- Continue to hold the option
- Exercise the option
Offsetting the option
Liquidating an option in the same marketplace where it was bought is the most frequent method of realizing option profits. Liquidating
an option prior to its expiration for whatever value it may still have is also a way to reduce your loss (by recovering a portion of your investment)
in the case of the futures price hasn't performed as you expected it would, or if the price outlook has changed.
In active markets, there ware usually other investors who are willing to pay for the rights your option conveys. How much they are willing to pay
(it may be more or less than you paid) will depend on (1) the current futures price in relation to the option's strike price, (2) the length of time
still remaining until expiration of the option and (3) market volatility.
Net profit or loss, after allowance for commission charges and other transaction costs, will be the difference between the premium you paid to
buy the option and the premium you receive when you liquidate the option.
Example: In anticipation of rising sugar prices, you bought a call option on a sugar futures contract. The premium cost was $950 and the commission
and transaction costs where $50. Sugar prices have subsequently risen and the option now commands a premium of $1,250. By liquidating the option
at this price, your net gain is $250. That's the selling price of $1,250 minus the $950 premium paid for the option minus $50 in commission and
transaction costs.
| Premium paid for option: |
$950 |
| Premium received when option is liquidated: |
$1,250 |
| Increase in premium: |
$300 |
| Less Transaction costs: |
$50 |
| Net Profit: |
$250 |
You should be aware, however, that there is no guarantee that there will actually be an active market for the option at the time you decide
you want to liquidated. If an option is too far removed from being worthwhile to exercise or if there is too little time remaining until
expiration, there may not be a market for the option at any price.
Assuming, though, that there's still an active market, the price you get when you liquidate will depend on the option's premium at that time.
Premiums are arrived at through option competition between buyers and sellers according to the rules of an exchange.
Continuing to hold the option
The second alternative you have after you buy an option is to hold an option right up to the final date for exercising or liquidating it. This
means that even if the price change you've anticipated doesn't occur as soon as you expected - or even if the price initially moves in the opposite
direction - you can continue to hold the option if you still believe the market will prove you right. If you are wrong, you will have lost the
opportunity to limit you losses through offset. On the other hand, the most you can lose y continuing to hold the option is the sum of the premium
and transaction costs. This is why it is sometimes said that option buyers have the advantage of staying power. You should be aware, however,
options decline in value as they approach expiration. (See "Time Value" on page 10.)
Page Six
Source: National Futures Association; published here with permission. This publication, Buying Options on Futures Contracts: A Guide to Uses and Risks,
is the property of the National Futures Association.
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