Option Terminology

There are several important terms the would-be user of options on futures should understand. They include:

call option:

Gives the buyer the right, but not the obligation, to buy a specific futures contract at a predetermined price within a limited period of time.

put option:

Gives the buyer the right, but not the obligation, to sell a specific futures contract at a predetermined price within a limited period of time.

holder:

The buyer of the option.

premium:

The dollar amount paid by the buyer of the option to the seller.

writer:

The option seller.

strike price:

The predetermined price at which a given futures contract can be bought or sold. Also called the exercise price, these levels are set at regular intervals. For example, if Treasury bond futures were at 79-00, T-bond option strike prices would be at 74, 76, 78, 80, 82, and 84.

at-the-money:

An option is at-the-money when the underlying futures price equals, or nearly equals, the strike price. For example, a T-bond put or call option is at-the-money if the option strike price is 78 and the price of the Treasury bond futures contract is at, or near, 78-00.

in-the-money:

A call option is in-the-money when the underlying futures price is greater than the strike price. For example, if Treasury bond futures are at 80-00 and the T-bond call option strike price is 78, the call is in-the-money. The put option is in-the-money when the strike price of the option is greater then the price of the underlying futures contract. For example, if the strike price of the put option is 80 and T-bond futures are trading at 77-00, the put option is in-the-money.

out-of-the-money:

A call option is out-of-the-money if the strike price is greater than the underlying futures price. For example, if T-bond futures are at 80-00 and the T-bond call option has an 82 strike price, the option is out-of-the-money. The put option is out-of-the-money if the underlying futures price is greater then the strike price. For example, if T-bond futures are at 77-00, and the T-bond put option strike price is 76, the put option is out-of-the-money.

                    Call option                        Put option
In-the-money        Futures > Strike             Futures < Strike
At-the money        Futures = Strike             Futures = Strike
Out-of-the-money    Futures < Strike             Futures > Strike

Options are considered "wasting assets." In other words, they have a limited life because each expires on a certain day, although it may be weeks, months, or years away. The expiration date is the last day the option can be exercised, otherwise it expires worthless.

For every option buyer there is an option seller. In other words, for every call buyer there is a call seller; for every put buyer, a put seller. The buyer of the option, unlike the buyer of a futures contract, need not worry about margin calls. However, the seller of the option is generally required to post margin.

If an option position is covered, the seller holds an offsetting position in the underlying commodity itself or a futures contract. For example, the seller of a Treasury bond call option would be covered if he actually owned cash market U.S. Treasury bonds or was long the Treasury bond futures contract.

If the writer did not hold either, he would have an uncovered or "naked" position. In such instances, margin would be required because the seller would be obligated to fulfill terms of the option contract in the event the contract is exercised by the buyer. It is imperative, therefore, that the seller demonstrate the ability to meet any potential contractual obligations beforehand. In addition, the seller of uncovered options on interest rate futures assumes the potential for significant losses.