4.1. Simple Options: Puts and Calls

Imagine that corn is currently trading at $4.20 and you believe that its price is going to rise quickly in the near-term. Maybe you think it will climb to $4.60 within the month. You might want to buy 10 corn futures contracts and profit from your belief that the price will rise, but anything can happen in the futures market, and you don’t want to take the risk of heavy losses. If the price should fall to $3.80, you could lose heavily.

Instead of buying corn futures, you buy a corn call option. The call option gives you the right to buy a corn futures contract at a specific price. This price is called the strike price.

With the call option you have the right to buy a corn futures contract at the strike price, regardless of how high the market price of corn rises. If the market rises as you expect, you can elect to purchase the contract and then resell it in the market at a profit.

Options don’t last forever, however. They usually last only a few months. What happens if corn doesn’t go up in price as you expect? Then the option will expire, and you’ve lost the cost of the option. But the cost of the option, called the premium, is less than the cost of buying a futures contract. So for a relatively small cost, you have purchased the right to make a fairly large profit. This is called leverage, and it is an advantage of options.

For every option that has a buyer, there is also a seller. The seller will receive the money that the buyer pays for the option, but he obligates himself to deliver the futures contract to the buyer if she decides to exercise the call and buy the corn futures contract. The seller of an option has an obligation to sell at the strike price. The seller of a call hopes and believes that the price of corn will not rise. If the price declines, he will not have to sell a futures contract, and he will pocket the premium as his profit. In contrast, if corn rises high enough, he will lose th