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One may be a buyer or seller of call or put options for a
variety of reasons.
A call option buyer, for example, is bullish. That
is, he or she believes the price of the underlying futures contract
will rise. If prices do rise, the call option buyer has three
courses of action available.
The first is to exercise the option and acquire the underlying
futures contract at the strike price. The second is to offset
the long call position with a sale and realize a profit. The
third, and least acceptable, is to let the option expire worthless
and forfeit the unrealized profit.
The seller of the call option expects futures prices
to remain relatively stable or to decline modestly. If prices
remain stable, the receipt of the option premium enhances the
rate of return on a covered position. If prices decline, selling
the call against a long futures position enables the writer to
use the premium as a cushion to provide downside protection to
the extent of the premium received. For instance, if T-bond futures
were purchased at 80-00 and a call option with an 80 strike price
was sold for 2-00, T-bond futures could decline to the 78-00
level before there would be a net loss in the position (excluding,
of course, margin and commission requirements).
However, should T-bond futures rise to 82-00, the call option
seller forfeits the opportunity for profit because the buyer
would likely exercise the call against him and acquire a futures
position at 80-00 (the strike price).
The perspectives of the put buyer and put seller are completely
different. The buyer of the put option believes prices for the
underlying futures contract will decline. For example, if a T-bond
put option with a strike price of 82 is purchased for 2-00, while
T-bond futures also are at 82-00, the put option will be profitable
for the purchaser to exercise if T-bond futures decline below
80-00.
In many instances, puts will be purchased in conjunction with
a long cash or long T-bond futures position for "insurance"
purposes. For instance, if an institution is long T-bond futures
at 82-00 and a T-bond put option with an 82 strike is purchased
for 2-00, the futures contract could, theoretically, fall to
zero and the put option holder could exercise the option for
the 82 strike price, assuming the option had not yet expired.
The seller of put options on fixed-income securities
believes interest rates will stay at present levels or decline.
In selling the put option, the writer, of course, receives income.
However, if interest rates rise, the buyer of the put
option can require the writer to take delivery of the underlying
instrument at a price greater than that in the new market environment.
Since an option is a wasting asset, an open position must
be closed or exercised, otherwise the option expires worthless.
The chart below illustrates what happens to the buyer and the
seller after an option is exercised.
FUTURES POSITIONS AFTER OPTION
EXERCISE
Call option Put option
Buyer assumes Long T-bond/note Short T-bond/note
futures position futures position
Seller assumes Short T-bond/note Long T-bond/note
futures position futures position
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