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.
Exercising the option
You can also exercise the option at any time prior to the expiration of the option. It does not have to be held until
expiration. It is essential to understand, however, that exercising an option on a futures contract means that you
will acquire either a long or short position in the underlying futures contract - a long futures position if you
exercise a call and a short futures position if you exercise a put.
Example: You've bought a call option with a strike price of $0.70 a pound on 40,000 pound live cattle futures contract.
The futures price has risen to $0.75 a pound. Were you to exercise the option, you would acquire a long cattle futures
position at $0.70 with a "paper gain" of $0.05 a pound ($2,000). And if the futures price were to continue to climb,
so would your gain.
But there are both costs and significant risks involved in acquiring a position in the futures market. For one thing,
the broker will require a margin deposit to provide protection against possible fluctuations in the futures price. And
if the futures price moves adversely to your position, you could be called upon - perhaps even within hours - to make
additional margin deposits. There is no upper limit to the extent of these margin calls.
Secondly, unlike an option which has limited risk, a futures position has potentially unlimited risk. The further the
futures price moves against you position, the larger your loss.
Even if you were to exercise an option with the intention of promptly liquidating the futures position acquired through
exercise, there's the risk that the futures price which existed at the moment may no longer be available by the time you
are able to liquidate the futures position. Futures prices can and often do change rapidly.
For all these reasons, only a small percentage f option buyers elect to realize option trading profits by exercising an
option. Most choose the alternative of having the broker offset - i.e. liquidate - the option at its currently quoted premium value.
Page Seven
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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