Options provide a rich variety of ways to speculate or hedge in the market. The risk and reward characteristics of options are much different than buying and selling outright (i.e., naked long or short position). The investor should thoroughly understand these characteristics of options before trading them.

Traders find options appealing because they feel options offer unlimited profit potential with limited risk. Others believe options are less risky because their loss is limited when buying them. In reality, options are just as risky as trading outright positions, but the risk is of different nature.

Options and futures contracts are similar. Both represent actions that occur in the future. Futures markets are contracts to either accept or deliver the actual physical commodity, while an option contract is a contract on the underlying futures contract. Options contracts give the farmer the right, but not the obligation, to buy or sell an underlying commodity. This underlying commodity is a futures contract. Due to these similarities and the fact that options are based on a futures contract, producers may question the value of using an options contract. To make a decision between using a futures contract or an options contract, producers need to evaluate both alternatives.

Options vs. Futures Contracts

An evaluation investigating advantages and disadvantages of futures and options contracts is necessary.

Advantages of Options

        1. No margin calls.

        2. Ability to take advantage of favorable price moves.

        3. Limited risk. The maximum potential loss is known when the option is purchased.

Disadvantages of Options

        1. Must pay a premium.

        2. Because of the "price insurance" (premium) associated with options, they may yield a lesser return than other marketing alternatives in certain market situations.

        3. If an option is exercised, a futures position, with all its financial and contract obligations, is assumed.

        4. Option premiums may not move penny for penny with futures contract moves "Delta" effect.

Advantages of Futures Contracts

        1. If price moves are favorable, the producer realizes the greatest return with this marketing alternative.

        2. No premium charge is associated with futures market contracts.

Disadvantages of Futures Contracts

        1. Subject to margin calls.

        2. Unable to take advantage of favorable price moves.

        3. Net price is subject to Basis change.

To make a true comparison between a futures contract and an options contract, the speculator/hedger should set up potential price scenarios based on his outlook of future market trends.

Commodity Futures Trading Info Center

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E-mail: info@trading-futures-markets.com

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