Chicago Mercantile Exchange. Options On Futures

Options on Futures An Introductory Guide Of all the products introduced by Chicago Mercantile Exchange, none can match the versatility of options on futures. While futures are powerful tools in their own right, options on futures allow the trader the potential to profit in virtually any market environment. With options, traders can construct strategies that profit in advancing, declining or even stable markets, while at the same time reducing risk and increasing leverage. In addition, because options also can be used to protect against adverse price moves in livestock, interest rate, foreign exchange and equity markets, they have become an increasingly popular hedging vehicle. Today corporate treasurers, bankers, farmers and equity portfolio managers throughout the world benefit from using options as risk management tools. Whether you are a trader or a hedger, one of the single most important advantages of options is that the option buyer has the potential to realize large profits while limiting risk to the amount paid up front for the option. However, before you incorporate options into your trading and risk management decisions, you should thoroughly investigate the risks, nomenclature and strategic uses of these instruments. The more background you have in options, the more likely you will be able to take full advantage of these powerful financial instruments. 1 Table of Contents The Vocabulary of Options . . . . . . . . . . . . . . 4 Some Options Fundamentals. . . . . . . . . . . . . 9 The Arithmetic of Options . . . . . . . . . . . . . . 13 Additional Terminology . . . . . . . . . . . . . . . 16 Basic Strategies . . . . . . . . . . . . . . . . . . . . 18 Review Questions . . . . . . . . . . . . . . . . . . . 21 3 1. The Vocabulary of Options Options are often thought of as difficult to learn – requiring numerical ability beyond most people. Actually, options are not difficult to understand once the basic vocabulary is mastered. Only the very advanced options concepts and strategies require any complex mathematics. Option An option is the right, but not the obligation, to buy or sell a particular futures contract at a specific price on or before a certain expiration date. There are two different types of options: call options and put options. Each offers an opportunity to take advantage of futures price moves without actually having a futures position. Call Option A call option gives the buyer the right to buy (go long) a futures contract at a specific price on or before an expiration date. For example, a September Yen 85 call option gives the buyer the right to buy or go long a Japanese Yen futures contract at a price of 85 (shorthand for $.0085/yen) anytime between purchase and September expiration. Even if Yen futures rise substantially above .0085, the call holder will still have the right to buy Yen futures at .0085. Put Option A buyer of a put option has the right to sell (go short) a futures contract at a specific price on or before the expiration date. For example, an October 70 Live Cattle put gives the put buyer the right to sell October Live Cattle futures at 70 cents/lb. Should Live Cattle futures decline to 64 cents/lb., the put holder (buyer) still retains the right to go short Live Cattle at 70 cents/lb. 4 Option Buyer The buyer, or holder, of an option can choose to exercise his right and take a position in the underlying futures.The call buyer can exercise his right to buy th