Introduction
Put options on futures contracts are one of the derivatives financial instruments that grant the buyer the right, but not the obligation, to sell a particular underlying asset or security at a specified strike price before the contract’s expiration. Put options on futures are an effective way to take a short position in a commodity. When an investor buys a put option, the risk is limited to the price paid for the put option (the premium) plus any commissions and exchange fees. Selling or buying a futures contract exposes the trader to unlimited losses.
What are Put Options on Futures?
Most traders do not exercise put options (or convert them into a short position in futures). Instead, they choose to close the put option position before expiration. Put options can also be sold (or written). The short position in a put option exposes the seller to potential losses up to the premium if the underlying commodity becomes worthless.
Example of a Long Put Option
Buying a soybean put option valued at $7.00 in November gives the buyer the right to sell a futures contract for soybeans in November at the price of $7.00 at any time before the option expires. If the buyer pays a premium of 20 cents or $1,000 (0.20 × 5000 bushels) for the put option when the option price moves to 30 cents, the profit would be 10 cents or $500.
Put Options as Price Insurance
Put options offer many useful purposes in commodity markets. Buying a put option grants the buyer the right, but not the obligation, to sell a specified amount of the commodity at a specified price (strike price) over a specified time (until expiration) for a price (the premium). Put options are considered insurance contracts that pay off when the commodity price falls below the strike price. A put option that is below the strike price is in-the-money. When the market price equals the strike price in a put option, the option is at-the-money, and when it is above it, the option is out-of-the-money.
Put Options Price Insurance
Put option buyers hedge against falling prices. The seller of the put option acts as the insurance company. Thus, the put option buyer has limited risk to the premium paid for the option, while the seller can only profit by the premium and has price risk to zero.
Example of a Put Option
For example, a cocoa futures put option valued at $3 with an expiration date in three months and a strike price of $50 would have the following profile at expiration:
- At $50 a ton or higher: The option will expire worthless. The put option buyer will lose $3, and the seller will gain the $3 premium.
- Between $47 and $50: The buyer will recover the difference between the strike price of $50 and the market price, while the seller will pay this amount.
- Below $47: The buyer will receive every dollar below $47, and the seller will pay this amount.
Conclusion
Put options on futures contracts are one of the derivatives financial instruments that allow traders to take a short position in a commodity. Put options serve as price insurance, enabling buyers to hedge against falling prices, while sellers act as insurance companies and bear price risks. Put options can be found on most major commodity exchanges in the areas of energy, precious metals, base metals, grains, soft commodities, and animal protein markets.
Source: https://www.thebalancemoney.com/put-option-809193
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