An option on a commodity futures contract gives the buyer, who pays a market determined price known as a "premium," the right (but not the obligation), within a specific time period, to exercise his or her option. Exercise of the option will result in the person being deemed to have entered into a futures contract at a specified price known as the "strike price." In some cases, an option may confer the right to buy or sell the underlying asset directly, and these options are known as options on the physical asset.
Understanding Options Contracts
To better understand options contracts, it is easiest to consider an example. Assume there is a stock that is trading under the symbol "ABC" on the stock market. An investor could buy an options contract to purchase shares of that stock at a set price on a set day. If ABC was trading at $10.00, the investor could buy an options contract to purchase the stock at $10.50 per share on a date three weeks into the future. If the stock reached the "strike" price of $10.50 per share or higher, the investor could "exercise" his option and purchase the stock at the price of $10.50.
If the stock did reach the $10.50 price, or perhaps an even higher price, the individual would likely either choose to exercise the option and buy his stock or he would be able to sell his "option to buy" at a higher price. If, however, the stock did not reach the $10.50 price and instead was selling for only $10.10, the investor would not exercise this option.
Options themselves can be bought and sold, so it is possible for an investor to make money on an options trade without ever exercising the option; this occurs because the value of the option can rise with the stock. Buying options also generally costs less than buying the stock. However, there is a greater risk because if the stock declines in value, the option can go to $0. Options contracts are usually sold in increments of 100, which means if you buy an options contract, you are buying the right to purchase 100 shares of the given stock at the strike price.
If you have more questions about options contracts, do not hesitate to contact an attorney.