Futures and Commodities - Types of Options

The world of option trading may seem quite daunting to a beginning trader, but in reality, there are only two types of options, Calls and Puts. Once you understand these terms, knowing which option to buy will become almost second nature.This article will discuss these two types of options at a beginner level. It will not be very complicated nor will there be any horrible maths involved!

Calls

Call options can be thought of the buyer taking a bet that the underlying asset (ie a certain parcel of shares, futures contract, etc) is going to rise in value. It gives the buyer the right, but not the obligation, to buy a certain asset for a certain price (called the Strike Price) before a certain expiry date. In essence, what you are doing is buying an opportunity. If you don't buy the asset before the option expires, you lose only the amount of money that you spent on the option, which is usually only a small fraction of the value of what the option controlled! You can always sell the option before it expires, either at a profit or to minimise a loss. Another choice is to exercise the option, which means you actually want to buy the asset it controls. As long as you have purchased the option, you can exercise the option at any point if it is an American-style option (European-style options can only be exercised on the expiry day)

Puts

Put options can be thought of as the buyer betting that that the underlying asset will fall in value. This type of option is an excellent instrument to have when you are trying to guard against losses in stock, futures contracts, or commodities that you presently own.

Put options give the buyer the right, but not the obligation to sell a specific quantity of the underlying asset at a predetermined price (ie the strike price) during a certain period of time. Like call options, if you choose not to exercise a put option before its expiry date, the total amount of money lost is the price paid for the option. However, as the price of the underlying asset drops in value, this drop in value is offset by the put option, which increases in value at the same rate the underlying asset is decreasing in value

An easy way to look at put options is to think of it as an insurance policy. If you have an insurance policy on your home that costs $500 for a year's protection from damage, if you go through the entire year without any damage, you have only lost $500. However, if your house is severely damaged (is has lost value), you can repair it (it maintain its value) with the insurance policy, which had only cost you $500, but paid for thousands of dollars in damage. The same thing can be applied to a share portfolio.

So that's all there is to it. If you think a share price is going to go up in value, buy a call option, as they increase in value with a rising market. If you think a share price is going to fall, buy a put option, as put options increase in value when the underlying asset price decreases

Doug has been writing online articles for the last 2 years. In addition to writing about options, forex and trading, he also writes about one of his favourite hobbies, building wooden playhouses. You can check out his latest website at WoodenPlayhouseInfo.com

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