A futures option, or option on futures, is an option contract in which the underlying is a single futures contract. The buyer of a futures option contract has the right (but not the obligation) to assume a particular futures position at a specified price (the strike price) any time before the option expires.
An option on a futures contract gives the holder the right to enter into a specified futures contract. If the option is exercised, the initial holder of the option would enter into the long side of the contract and would buy the underlying asset at the futures price. A short option on a futures contract lets an investor enter into a futures contract as the short who would be required to sell the underlying asset on the future date at the specified price.
Aside from commissions, an investor can enter into a futures contract with no upfront cost whereas buying an options position does require the payment of a premium. Compared to the absence of upfont costs of futures, the option premium can be seen as the fee paid for the privilege of not being obligated to buy the underlying in the event of an adverse shift in prices. The premium is the maximum that a purchaser of an option can lose.
All call options have the following three characteristics:
- Strike price: this is the price at which you can buy the stock (if you have bought a call option) or the price at which you must sell your stock (if you have sold a call option).
- Expiry date: this is the date on which the option expires, or becomes worthless, if the buyer doesn’t exercise it.
- Premium: this is the price you pay when you buy an option and the price you receive when you sell an option.
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