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What is an Options Contract

Meta Pro Trader Options Education series.
What is an Options Contract


The price at which the underlying futures contract may be bought or sold is the exercise price, also called the strike price. An options contract affords the right to buy or sell for only a limited period of time; each options contract has an expiration date.

When purchasing options, risk is limited to the investment made, which is premium and all fees paid.

On the opposite side, a seller, or writer of an options contract incurs an obligation to perform, should an options contract be exercised by the purchaser. The writer of a call incurs an obligation to sell a futures contract and the writer of a put has an obligation to buy a futures contract.

Buyer

Has the right to buy a futures contract at a predetermined price on or before a defined date.

Expectation: Rising prices

Has the right to sell a futures contract at a predetermined price on or before a defined date.

Expectation: Falling prices

 

Seller 

Grants right to buyer, so has obligation to sell futures at a predetermined price at buyer’s sole option

Expectation: Neutral or falling prices

Grants right to buyer, so has obligation to buy futures at a predetermined price at buyer’s sole option

Expectation: Neutral or rising prices

 

In return for the rights they are granted, options buyers pay options sellers a premium. There are four major factors affecting the price of an options contract:

The price of a futures contract relative to the options strike price.

Time remaining before options expiration.

Volatility of underlying futures price.

Interest rates.

An options contract is a wasting asset. It has an initial value that declines, or wastes away, as time passes. Depending upon the movement of an options price, the buyer will choose one of three alternatives for terminating an options position:

Exercise the options contract.

Liquidate it by selling it back on the Exchange.

Let it expire.

While liquidation is the most common choice, a small percentage of buyers choose to exercise their options, particularly if their strategy calls for acquiring a long or short futures position at the strike price. The ability to trade in and out of positions is the great advantage of standardized options contracts.

If the futures price does not move far enough for an exercise to be worthwhile, or moves in the opposite direction, buyers can simply let their options contract expire valueless.

Because trading on the Exchange is conducted among anonymous counterparties, when an options contract is exercised, the Exchange randomly assigns an options writer to fulfill the obligation.

As in the futures market, options trading takes place in a primarily open outcry auction market on the Exchange. While the value of futures is tied to the underlying cash commodity through the delivery process, the value of an options contract is related to the underlying futures contract through the ability to exercise the option.


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