What Is an Option?

An option is simply the right, but not the obligation, to buy or sell something at a predetermined price at anytime within a specified time period.

This contract or option gives the buyer the right, but not the obligation, to buy or sell a particular commodity-such as stocks, property, or futures contracts-at a certain price for a limited period of time. The option seller, on the other hand, is obligated by this same agreement to buy or sell the commodity stated in the contract, at a certain price, if the option is exercised by the option buyer.

There are two distinct types of options: put options and call options.

A put option gives the option buyer the right to sell the underlying commodity, while a call option gives the option buyer the right to buy the underlying commodity. In the case of options on futures, the underlying commodity is a futures contract.

Options Example

Let's consider a ca1l option to purchase land:
Assume you have a neighbor who is offering to sell 120 acres of cropland at a price of $1,200 an acre. You would like to own the land but, for any number of reasons, you are unable or unwilling to purchase the land right now. What can you do to lock in the right to buy the land at $1,200 an acre? You can persuade your neighbor to sell you an option to purchase the land anytime during, say, the next six months at that price. For this privilege, you pay the neighbor $25 an acre (or $3,000).

In this scenario, the option expires in 6 months, and it costs $25 an acre for the right to buy land at $1,200 an acre. If we applied option terminology to this example we'd say option expiration is in six months, the option premium or cost is $25 an acre, and the call option has a strike price of $1,200 an acre-you have the right, but are not obligated, to buy land at $1,200 an acre.

Later, if you decide not to buy the land, you can simply let the option expire. Or better yet, if the option rights are transferable, you may be able to sell them to someone else, possibly for more than you paid for them. The point is, you are not obligated to make a purchase-the choice is yours.

There's a lot more to learn about options trading and the risks involved, contact Argo Futures and request a free options trading guide published by the CBOT. 1-888-598-ARGO(2746)