A put option is a derivative of a futures contract. The purchase of a put option gives the buyer the right, but not the obligation, to sell a futures contract at a designated strike price before the contract expires.
In commodity markets, buying put options is often a low-risk way to take a short position in a market. When one purchases a put option, the risk is limited to the price paid for the put option (the premium) plus any commissions and exchange fees. Buying or selling a futures contract exposes a trader to unlimited losses.
Most traders do not exercise put options (or convert into a short futures position), rather they chose to close a put option position before it expires.
One can also sell (or write) put options. A short position in a put option exposes the option seller to unlimited risk.
A long put option is a short position.
Example of a Long Put Option
The purchase of a November $7.00 soybean put option gives the buyer the right to sell a November soybean futures contract at $7.00 anytime before the option expires.
If the buyer pays a premium of 20 cents or $1,000 (.20 x 5,000 bushels) for the put option when the price of the option moves to 30 cents a profit of 10 cents or $500 will be the result.
Put Options Are Price Insurance
Options serve many useful purposes in commodity markets. The purchase of a put option gives the buyer the right, but not the obligation to sell a specified amount of a commodity at a specified price (the strike price) for a specified period (until the expiration date) for a price (the premium). Put options are insurance contracts that pay off when the price of a commodity moves lower, below the strike price. A put option below the strike price is an in-the-money put. When the market price is equal to the put option strike price the option is at-the-money, and when it is above, the put is out-of-the-money.
Put option buyers insure or hedge themselves against lower prices. The seller of a put option acts as the insurance company. Therefore, the buyer of the put has a risk limited to the premium paid for the option while a seller can only profit by the amount of the premium and has price risk all the way down to zero. For example, a $3,000 put option on cocoa futures with an expiration date in three months for $50 per ton would have the following risk profile at expiration:
- At or above $3,000 the option would expire worthless. The buyer of the option would lose $50, and the seller would profit by $50.
- Between $3,000 and $2,950- the buyer will recoup the difference between the $3,000 strike price and the market price while the seller will pay that amount.
- Below $2,950- the buyer receives each $1 below $2,950, and the seller will pay that amount.
While this example is described using cocoa futures, it applies to other commodity markets. Put options are derivatives of futures contracts while futures are derivatives of the physical commodity. There are options available on most major commodity exchanges in energy, precious metals, base metals, grain, soft commodities and animal protein markets.
Options are the only vehicles that allow traders, speculators, and investors to make money when a market does not move. The chief determinate of put options and all options for that matter is implied volatility. Implied volatility is the variance that market consensus believes will exist during the life of the option contract.