#1 Futures Contract, Options, Expiry? Confused?

by admin on February 21, 2012

This post will target mostly at explaining the few terms that you will come across while using this strategy.
I will try my best to present it as simple as possible. Just a side note if you come across anything that seems to be wrong, please feel free to point it out as I am learning along the way as well :D.
Thanks in advance for that.

Futures Contract

Futures contract must have an underlying product. For example a Corn March futures contract would mean a buyer or seller is willing to buy or sell corn at a specific price and size (corn normally is 5,000 bushels) for delivery in the month of March. So as you can see from the example, there must be a product (Corn), a future date (March in this case), an agreeable price (which is traded in an exchange) and some form of specification like the size, grade of the corn and so on.
The underlying product can range from stock indexes, currencies to commodities.
Normally people will not wait to seek delivery and will prefer to close the trade way before the expiry date. It can be seen as some form of hedging or speculation.

When I just got started I confused the futures contract price with the cash price or spot price for corn. Sidetrack a bit, cash price or spot price refer to the actual current price for corn.
So the spot price for corn might be $5 but the March futures contract price is at $6. The additional $1 is the carry charges (the cost for storage, insurance or any other charges). For example a buyer might not require the corn immediately thus the buyer might consider to purchase a futures contract to seek delivery in March therefore the additional $1 is paid for the expenses incurred by the farmer.

*Note: Futures contract price will not always be higher than the spot price due to several reason like for example Dec Corn contract might be lower than the current spot price as Dec is near the harvesting period for corn thus the market view the price to be lower.

Options

Probably if you have already read the “The Complete Guide to Option Selling” by James Cordier and Michael Gross, you would know that the strategy that I am following involve the process of selling options on futures contract.
So what is an options? Options is also a contract whereby buyer and seller will agree upon a price and a specific date that the options will expire. Buyer of options are not obligated to exercise the options but the seller are obligated to deliver what is stated in the contract. So do take note as this strategy involved being a seller.
There are basically two types of options namely the call options and the put options. Another term to be familiar with is the strike price which is the target price of the options.

As can be seen from the picture above, a person bullish with the price of corn will probably buy a call options with a strike price of let say $6 that will expire in another 30 days. If the price of corn reach $7 by the end of 30 days, the buyer of the option will be richer by $1 ($7 – $6 = $1). So call options for prices higher than the strike price and put options for prices lower than the strike price.

One thing probably good to mention is that of opening interest, it refer to the total number of options contract that are currently opened.
An example is as shown below:

Buyer A buy 1 call option and it was match to Seller B that sell 1 option. –> Opening interest increased by 1.

Now Buyer A decided to close out or sell off his option contract with Seller B to Buyer C. –> Opening interest maintain as 1 as there is only one contract remain opened.

Buyer A decide to buy another 2 call options from Seller D who is willing to sell that 2 call options. –> Opening interest increased by 2. So opening interest now is at 3.

Up till this point. Buyer C is in a contract with Seller B and Buyer A is in a contract with Seller D.

So when Buyer A decided to close 1 of his call option and at the same time Seller B decide to close 1 of his call options. –> This will cause the opening interest to be decreased by 1 since one existing contract was closed out.

Hopefully I did not confused you further for the opening interest but do feel free to ask any questions by leaving a comment and I will try my best to answer any of your questions.

This is definitely not an exhaustive guide and I do recommend to read up more on options and you can consider reading “Getting Started in Options”  3rd Edition by Michael C. Thomsett.

Please do leave a comment or any questions you may have. Thank you for reading. 😀

Disclaimer: The author is not a licensed financial advisor and the information is provided for educational and information purposes only.
Trading commodity futures and options have large potential rewards but also contains a high level of risk and is not suitable for all investors.
Only risk capital should be used when trading futures or options.
None of the information provided constitutes a solicitation of or a recommendation to buy or sell any futures or options contracts.
Please seek the advice of a professional financial advisor before investing your money in any financial instrument.

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