Whereas a call option conveys the right to purchase (go long) a particular futures contract at a specified price, a put option conveys the right to sell (go short) a particular futures contract at a specified price. Put options can be purchased to profit from an anticipated price decrease. As in the case of call options, the most that a put option buyer can lose, if one is wrong about the direction or timing of the price change, is the option premium plus transaction costs. Had you been wrong about the direction or timing of a change in the underlying futures price, the most you could have lost would have been the premium paid for the option plus transaction costs. However, you could have lost the entire premium.
A put option gives the holder the right, but not the obligation, to sell the underlying interest at a known price, which is the strike price of the option at or prior to option expiration. The option buyer pays the option premium. The holder can affect the sale of the underlying interest by exercising the option. The seller of a put option receives the option premium but, in return, must buy the underlying interest from the option holder if the holder exercises the option.
How Option Premiums are Determined
Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers. Three major variables influence the premium for a given option:
- The option's exercise price, or, more specifically, the relationship between the exercise price and the current price of the underlying futures contract is a key factor. All else being equal, an option that is already worthwhile to exercise (known as an "in-the-money" option) commands a higher premium than an option that is not yet worthwhile to exercise (an "out-of-the-money" option).
- The length of time remaining until expiration is very important. All else being equal, an option with a long period of time remaining until expiration commands a higher premium than an option with a short period of time remaining until expiration because it has more time in which to become profitable. Said another way, an option is an eroding asset. Its time value declines as it approaches expiration.
- The volatility of the underlying futures contract needs careful consideration. All else being equal, the greater the volatility the higher the option premium. In a volatile market, the option stands a greater chance of becoming profitable to exercise.
Option writers, or grantors sell options. Their sole reason for writing options is to earn the premium paid by the option buyer. If the option expires without being exercised (which is what the option writer hopes will happen), the writer retains the full amount of the premium. If the option buyer exercises the option, however, the writer must pay the difference between the market value and the exercise price. It should be emphasized and clearly recognized that unlike an option buyer who has a limited risk (the loss of the option premium), the writer of an option has unlimited risk. This is because any gain realized by the option buyer if and when one exercises the option will become a loss for the option writer.
Selling options, whether calls or puts, is riskier than buying options since the downside risk (or potential loss) is similar to that of an outright futures position. For this reason, options sellers must deposit margin just like for a futures transaction, and may be required to deposit additional margin if prices move adversely. Beginning traders should be very cautious when considering the sale of an option.
Option sales can be covered or uncovered. A call option sale is covered if the seller owns the futures underlying the option. For instance, the seller of a December gold call option is covered if they also own or are long December gold futures. Alternatively, if the call option seller does not own the underlying futures, then the sale is uncovered or naked. Uncovered option sales are riskier than covered option sales since in the former, the option seller must enter the market to acquire the underlying futures if the option is exercised, and thus faces this price risk. The covered seller, in contrast, already owns the underlying futures and does not face this price risk. A put option sale is covered if the seller is already short the underlying futures, and uncovered if the seller has no such position in the underlying futures. Again, an uncovered sale is riskier than a covered sale.