Session 1, Lesson 3 / Strikes
DEFINING PUTS AND CALLS
From our previous lesson, we have already learned that an option is a contract to buy or sell a futures contract. This lesson will deal with the two types of options which are available, namely puts and calls. In any of the futures products where options are traded, you will always have both puts and calls.
It is important to understand that puts and calls are two very separate and distinct contracts. Put options are contracts with specific characteristics and obligations, and call options, while having similar characteristics, are actually very different from put options. A Ford pick-up truck and a Ford car are both Fords and they’re both used for transportation, but their function and appearance are very different. Both puts and calls are options, but they are two separate contracts which each stand alone.
In an earlier lesson, you learned that every option has a buyer and a seller. That statement applies to both puts and calls. Every put option contract has a single buyer and a single seller. Many contracts may be traded in a day, but every contract maintains that one-on-one relationship. The same is true for call options. There is still one buyer and one seller for every call option contract. A very fundamental fact to learn at this time — and one which is often confused by many people learning about options — is to maintain the distinction between puts and calls as being two separate products.
When you become a buyer of a put option and decide you no longer need that contract, you can simply sell the contract back to a new buyer. The same thing is true with call options. If you buy a call option and no longer have the desire to own it, you can simply sell it back. You never mix the two with the objective of closing or exiting your position. Some people believe that when they buy a put option, they must buy a call option to offset it or get out of the put. That is not true. If you buy a Ford pick-up truck you do not buy a Ford car to offset or get rid of the truck you bought. Puts and calls are completely separate in this regard.
We’ve said that buying an option contract gives you the right to buy or sell the underlying futures contract. Put options give the buyer the right, but not the obligation, to sell the underlying futures contract. Call options give the buyer the right, but not the obligation, to buy the underlying futures contract. Those two statements are commonly thrown around in defining options, but I think it’s important to look at them a bit more carefully. First of all, you’ll notice we use the words “the buyer of the option”. Normally as a hedger (someone trying to manage risk), you will be in the position of initially buying an option, whether it is a put or a call. The determination of whether you buy a put or a call is dependent upon your trading plan and the hedging strategy that you are implementing. In Lessons 8 – 11, we will be dealing with those strategies in great detail.
When I say the underlying futures contract, I’m referring to that link between an option and a futures contract. When you buy a put option, you have the right but not the obligation to turn that contract into a futures contract. When you’re buying a put option it becomes even more specific in that you have the right to turn it into a very specific futures contract in a certain contract month at a very specific price. That specific price is called a strike price, but more on that later.
Let’s look at an example to help bring this into focus. As part of the assignment from the last lesson, you were asked to look up the premium for a Mar 290 corn put. That is a very specific and unique contract. By becoming the buyer of the option, you have the right, but not the obligation, to sell March corn futures at $2.90. In exchange for being granted that option or that right, you would pay the premium to the person selling the option. The amount of premium paid is negotiated between the buyer and the seller. You are represented in these negotiations by a broker. The actual trading occurs in the pits at the commodity exchange.
In general, put options are used by hedgers to protect themselves from the risk of falling prices. Normally a farmer involved in producing a crop or livestock would use put options as a hedge. We’ve mentioned before that a put option gives you the right, but not the obligation, to sell at a specific price. In the case of our March corn example, you have the right to sell at $2.90, thereby creating what is known as a floor price for your corn. Bear in mind this is not the actual guaranteed price for your cash product because you must still subtract your cost of the option including premium and commission and the appropriate basis level to arrive at a cash price expectation.
When I say that the put option gives you the right, but not the obligation, to sell at $2.90, that means if corn prices are higher than that you can choose not to use your option and instead sell for the higher current market price. As the buyer of the option, you have a choice. You can choose to use your price protection and sell at $2.90 if prices are below that level, or you can choose to sell at the higher price if the market is above that level. As the buyer, the choice is entirely yours and the seller can never force you to take action of any type.
The buyer of a call option has the right to buy the underlying futures contract at the stated price. Referring again to our assignment from Lesson 2, the hedger who would buy a Jan $66 feeder cattle call option would have the right but not the obligation to buy Jan feeders at $66. If feeders were above that price, he is guaranteed that he can still buy them at $66. If feeders are below that level, however, he has the choice and would choose to purchase at a lower level and not use the option. In the case of call options, you can see that the buyer uses them to set a price ceiling for a product which he must purchase.
Let’s go back to our example of options being like insurance. When you buy an insurance policy, you pay a certain amount of premium for coverage or protection for a certain period of time. Options are very similar. An option contract is only good for a certain length of time. It would be easy if a trader were considering a Dec corn put option and knew that Dec options expired or ran out in Dec. Some options expire during the month prior to the futures contract month. (always check with your broker for specific expiration dates when actually trading a contract).
Jan. feeder cattle 66 call = $1.05 / Oct. feeder cattle 64 put = .75 / Feb. live hog 44 put = 1.00 / Apr. live hog 44 call = 2.60
Feb. live cattle 66 call = 1.50 / Apr. live cattle 64 put = 2.00 / Dec. corn 280 call = .10 / Dec. corn 280 put = .12
Mar. corn 290 call = .16 / Mar. corn 290 put = .12
SUMMARY — There are two types of options contracts — puts and calls. — A put option gives the buyer the right, but not the obligation, to sell the underlying futures contract at a specific price within a specific period of time. — A call option gives the buyer the right, but not the obligation, to buy the underlying futures contract at a specific price within a specific period of time. — An options contract does not go on forever, but rather has a limited life and ultimately stops trading. — The amount paid for an option is negotiated between the buyer and the seller. — Puts and calls are separate and distinct contracts and are not interchangeable. Lesson 4 wIll look more specifically at premium, what it is, and how it’s calculated.