9.3.1-HEDGING AND OTHER OPERATIONS-PUT AND CALL OPTIONS
Put and call options
Another approach to risk management has also demonstrated a growing usefulness: the purchase of options on futures as price insurance. This strategy has the appeal of limiting the losses in the futures market while protecting upside price potential. It is particularly attractive to small producers who may wish to establish a price floor (above the cost of production) without committing capital to a margin account. Options alone or in combination with futures offer greater flexibility for risk managers in the design of their hedging strategies. There are two options around which all option strategies are based: the call and the put.
confers the right, but not the obligation, to buy a futures contract at an agreed price between the date of concluding the contract and the time the option contract expires. If the buyer decides to exercise the option then the seller of the option is obliged to deliver the futures.
confers the right, but not the obligation, to sell a futures contract at an agreed price: the seller of the option is obliged to accept the futures if the option is exercised.
Of course the option holder will only exercise the option if it makes financial sense, that is, if the option shows a profit.
The main thing to remember about options is that when you purchase an option, you pay a premium and your potential for loss is limited to the amount of that premium. The option can be exercised at any time, no matter how far the market moves, so there is potential for unlimited return less the amount of the premium. Also, you are not required to deposit any margin when purchasing options. Options work rather like insurance:
the payment of a premium provides a level of protection against loss.
When you sell (or write) options, the reverse is true. The option writer is paid a premium (limited return) and must perform no matter how far the market moves (unlimited risk). Option writers must maintain margin accounts. Because of the potentially unlimited risk, only experienced hedgers and traders should consider selling or writing options.
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