Why have options on futures contracts become so popular amongst the investment class Mainly because they have a KNOWN and LIMITED RISK but they also have an UNLIMITED PROFIT POTENTIAL.
Options on futures contracts have become an attractive investment for many individuals seeking to profit from significant price movements — either upward or downward — in today’s increasingly volatile and often uncertain investment environment.
Approximately 300 million options, encompassing a wide variety of basic commodities and financial products, are traded annually on the nation's regulated exchanges.
As the title states, this booklet has been prepared to provide plain-language answers to 25 important questions about purchasing options as an investment. Hopefully, they will become helpful in deciding whether options are for you.
1. What is my maximum risk if I buy an option? The nature and amount of downside risk is a good first question to ask about any investment you may be considering- In the case of options, the maximum risk is that you could potentially lose the money — known as the premium — which you invested to purchase that particular option and any brokerage and transaction costs involved in making the investment.
2. Does this make options a risky investment? It makes options an inappropriate investment for some people. This is why your broker will ask you questions that may seem somewhat personal about your financial situation and objectives and will inquire that you acknowledge reading and understanding a Risk Disclosure Statement. This is important information and should be considered in deciding whether options are an appropriate investment for you. Money needed for family living, insurance protection, and basic savings programs obviously should never be committed to any form of investment that involves substantial risk, regardless of the opportunity for profit.
3. Why have options on futures become such an increasingly popular investment? Options make it possible to realize a potentially substantial profit - perhaps in a short period of time - with a relatively small investment and with a known and limited risk. Under no circumstances can the loss exceed the cost of purchasing the option. Other advantages include: The leverage inherent in options. The liquidity provided by established competitive option markets Investment diversification. The flexibility to respond rapidly to any Market Opportunities The ability to follow the value of your investment on a day-to-day basis. The staying power to weather temporary price setbacks without incurring additional risk or costs. Freedom from the margin calls that many other investments are subject to The opportunity to realize profits during periods of declining prices as well as during periods of rising prices.
4. What exactly is an option? There are exchange trading in two types of options on futures contracts, known as call options and put options. Which one to consider investing in will depend entirely on your price expectations. That is, on whether you expect the price of a particular commodity to go up or whether you expect it to go down
a. Call option. Purchasing a call gives you a specific locked-in price at which you have the right — but not the obligation — to buy a futures contract on a commodity that you expect to increase in value. Thus, if you look for, say, the price of gold to go up, you would buy a gold call option. You can sell at any time during the life of your option .
b. Put option. Purchasing a put gives you a specific locked-in price at which you have the right — but not the obligation — to sell a futures contract on a commodity that you expect to decrease in value. Thus, if look for the price of gold to go down, you would buy a gold put option. Once again you can sell these options at any time during the life of the contract.
One easy way to remember which is which is to think of the terms CALL UP and PUT DOWN. A call is a way to profit if prices go up. A put is a way to profit if prices go down.
If and when the market price of the commodity moves in the direction you anticipated, this will be reflected on a day-by-day basis in the value of your option rights. The more valuable your option rights become, over and above what you paid for them, the larger your profit will be when you decide to sell or exercise the option.
5. Other than call and put, what terms do I need to be familiar with? Just a couple. You should know what’s meant by an options premium and by its strike price.
a. Premium. Used in connection with options, premium has the same meaning as when used in connection with insurance. It's the price that you pay to buy a given option.
b. Strike Price. This is the specific dollars and cents price at which the option gives you the right to buy a particular commodity in the case of a call or to sell the commodity in the case of a put. The strike price is stated in the option Example: If a call option gives you the right to buy 100 ounces of gold at a price of $300 an ounce, $300 is the strike price. At any given time, there is likely to be trading in options with a number of different strike prices.
6. How are profits realized in option investing?
Generally by instructing your broker to sell your option rights to someone else (who may expect them to further appreciate). The sale will be accomplished on the trading floor of the exchange (the same exchange where the option was bought) and your net profit will be the difference between the price that you originally paid for the option and the higher price that you are able to sell it for, less brokerage and transaction expenses. The mechanics are no more complicated than, for example, selling shares of common stock that have appreciated.
An alternative to selling a profitable option is to exercise the option rights yourself. Doing this, however, would result in your actually acquiring a position in the futures market — which could require an additional investment on your part and involve significantly greater risks. Most investors therefore prefer to realize their profits by simply selling the option at its increased value.
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