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Introduction to Options

This course is reproduced with the permission of XPRESSTRADE

Options Terminology

There are several important terms the would-be user of options on futures should understand. They include:

•  Call Option: Gives the buyer the right, but not the obligation, to buy a specific futures contract at a predetermined price within a limited period of time.

•  Put Option: Gives the buyer the right, but not the obligation, to sell a specific futures contract at a predetermined price within a limited period of time.

•  Holder: The buyer of the option.

•  Premium: The dollar amount paid by the buyer of the option to the seller. This is also the amount received by the seller, or "writer," of the option.

•  Writer: The option seller.

•  Strike Price: The predetermined price at which a given futures contract can be bought or sold. Also called the exercise price, these levels are set at regular intervals. For example, if Treasury Bond futures were at 110-00, examples of T-Bond option strike prices would be 106, 108, 110, 112, 113, and 114.

•  At-the-Money: An option is at-the-money when the underlying futures price equals, or nearly equals, the strike price. For example, a T-Bond put or call option is at-the-money if the option strike price is 110 and the price of the Treasury Bond futures contract is at, or near, 110-00.

•  In-the-Money: A call option is in-the-money when the underlying futures price is greater than the strike price. For example, if Treasury Bond futures are at 112-00 and the T-Bond call option strike price is 108, the call is in-the-money. This is because the call option gives the holder the opportunity to buy the futures contract at 108-00, when the market is currently trading at 112-00. The put option is said to be in-the-money when the strike price of the option is greater then the price of the underlying futures contract. For example, if the strike price of the put option is 112 and T-Bond futures are trading at 108-00, the put option is in-the-money. Any trader would love the opportunity to sell futures at 112-00 when the market is trading much lower, at 108-00.

•  Out-of-the-Money: A call option is out-of-the-money if the strike price is greater than the underlying futures price. For example, if T-Bond futures are at 110-00 and the T-Bond call option has an 116 strike price, the option is out-of-the-money. If this situation persists until option expiration, the option will expire worthless -- the buyer will have lost the full premium he paid, and the writer will keep the full premium received. The put option is out-of-the-money if the underlying futures price is greater then the strike price. For example, if T-Bond futures are at 108-00, and the T-Bond put option strike price is 102, the put option is out-of-the-money. In this case, the put option buyer will lose the entire premium paid, while the put writer will keep the entire premium.

The Option Is...

Call Option

Put Option

In-the-Money

Futures > Strike

Futures < Strike

At-the Money

Futures = Strike

Futures = Strike

Out-of-the-Money

Futures < Strike

Futures > Strike

Next chapter: Option Valuation

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