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What is an option?

An option on a futures contract is the right, but not the obligation, to buy or sell the underlying futures contract at a predetermined price on or before a given date in the future.

Here’s a simple example:

Suppose your company is considering moving to a new city, and you may need to move. You could buy a house in the new city, just in case, but that may not be the best use of your capital. And if the company decides not to move, then you have a house you don’t need.

But, what if you could buy an option on a house in the New City?

You will need to pay the owner of the house for this “right”, and the cost of that right is called the option premium.

If the company moves, you would exercise your option to purchase the house at the predetermined price. If the company does not move, then you would simply not exercise your right or option to buy the house. When this happens, the owner of the house will still keep the option premium.

Options on futures work fundamentally the same way, but with more standardized terms, and options permit you to lock in price but with an added layer of flexibility. For example, when you buy an option on a future, you pay an upfront premium, and agree to buy that particular futures contract at a specific price.

You have the right but not the obligation to exercise your option at that price and receive the futures contract. So if prices move against you, you have the option of not exercising the contract.

Every option transaction must have a buyer and a seller:

Buyers pay the premium to the seller, plus all trading costs such as exchange fees, National Futures Association and order routing system fees. Sellers hold the risk of price movement.

Options Short Selling:

While selling options on futures can also be a profitable strategy, it must be stressed that it entails substantially more risk than buying options on futures. An individual who sells options on futures has the potential to lose large sums of money. The strategy should therefore only be initiated by individuals who fully understand options on futures as well as the considerable risk associated with option selling, and who can meet the financial requirements.

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