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Introduction to Options

This course is reproduced with the permission of XPRESSTRADE Back to Trading 101 Index

Buying Put Options

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 -- but not the obligation -- to sell ("go short") a particular futures contract at a specified price. Put options can be purchased to profit from an anticipated price decrease in the underlying futures.

As in the case of call options, the most that a put option buyer can lose, if he is wrong about the direction or timing of the price change, is the option premium plus transaction costs. Example: Expecting a decline in the price of Gold, you pay a premium of $1,000 to purchase an October 420 Gold put option. The option premium will be deducted from your account at the time you purchase the put option. The put gives you the right to sell a 100-ounce Gold futures contract for $420 an ounce.

Assume that, at expiration, the October futures price has -- as you expected -- declined to $390 an ounce. The option giving you the right to sell at $420 -- above the current futures market price -- is therefore valuable. The put option in this example can be sold or exercised, in fact, for a gain of $30 an ounce. On 100 ounces, that's $3,000. After subtracting $1,000 paid for the option, your net profit comes to $2,000. In this case, you made $2,000 on an initial investment of $1,000, which represents a 100% return.

The Trader Buys...

Futures Position Upon Option Exercise...

A put option

Short futures position at the strike price

Had you been wrong about the direction or timing of a change in the Gold futures price, the most you could have lost would have been the $1,000 premium paid for the option plus transaction costs. There's always the chance, if the option expires "out-of-the-money" (worthless), that you could lose the entire premium you paid. That's the risk associated with purchasing options.

Here's an important point for both call and put option buyers alike: One of the main attractions of buying options is that unlike the buyer of a futures contract, the option purchaser need not worry about margin calls. The option buyer need only pay for the option -- once the premium has been deducted from the buyer's account, he has no further risk, and therefore, a margin deposit is unnecessary, and there will never be any margin calls.

Next chapter: Option Premiums

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