Wednesday November 2, 2005

Options Series Part 1

The Basic Idea

Over the years I’ve found that many people avoid the commodity option market simply because they don’t quite understand how it works.  Since option trading can be such a huge source of profit (or income), it’s important that everyone who wants to be a successful investor understands how and why options work.

An option is simply an agreement between two parties about the right to buy (a call) or the right to sell (a put) something in the future.  The most common option would be one involving real estate.  If you were to purchase a 5 year option on a piece of land, you would probably be paying for the right to buy that land for a set value at any time during the next 5 years.  If during that 5 year period, you decide not to buy the land, the current owner gets to keep the money (premium) that you paid for your option.  If on the other hand, you do decide to buy, you pay the agreed upon price even if the land increased significantly in value.  The premium paid for the option is added to the purchase price of the land.

In commodities, options work much the same way.  One of the differences though is that commodity markets move a lot faster than land values.  It’s not unusual to do options trades that only last 1 month.  Also in commodities, you can issue (write or sell) an option even though you don’t own the product itself.  In lieu of ownership the exchange requires that you put up margin money (a performance bond) to ensure that you will be able to furnish the product if the option buyer decides to exercise his option.

The option buyer is in the relatively safe position of only putting up the premium, thereby limiting his risk to the amount of money paid for the option.  If the market goes wildly in his favor, he can either sell his option on the open market to someone else for a much higher price or exercise his option, thereby receiving the actual product at a previously determined price (strike price), which he can then sell on the open market.  If the market goes against the buyer or fails to move at all, he can just let the option expire worthless and only loses the money he paid for the option.  The option buyer is always trying to decide where and how far a market will go.

The Option seller takes on a greater risk.  Because although he receives a premium from the buyer, he also takes on the responsibility to provide the buyer with the market position at the strike price if called upon to do so during the life of the option.  This added responsibility justifies his acceptance of the premium.  The option seller is always trying to decide where and how far the market won’t go.

It’s important to understand that there is a market in the options themselves and they can be bought and sold within that market at any time.

Next time let’s talk about strike prices and premiums.