An option on a futures contract is the right, but not the obligation, to buy or sell the underlying futures contract at a predetermined price on or before a given date in the future.
Suppose your company is considering moving to a new city, and you may need to move. You could buy a house in the new city, just in case, but that may not be the best use of your capital. And if the company decides not to move, then you have a house you don’t need.
But, what if you could buy an option on a house in the New City?
You will need to pay the owner of the house for this “right”, and the cost of that right is called the option premium.
If the company moves, you would exercise your option to purchase the house at the predetermined price. If the company does not move, then you would simply not exercise your right or option to buy the house. When this happens, the owner of the house will still keep the option premium.
Options on futures work fundamentally the same way, but with more standardized terms, and options permit you to lock in price but with an added layer of flexibility. For example, when you buy an option on a future, you pay an upfront premium, and agree to buy that particular futures contract at a specific price.
You have the right but not the obligation to exercise your option at that price and receive the futures contract. So if prices move against you, you have the option of not exercising the contract.
Every option transaction must have a buyer and a seller.
Buyers pay the premium to the seller, and sellers hold the risk of price movement.
Options can be used like insurance policies to limit losses on a futures contract.
They can also be used for speculative purposes, whether you are selling options to receive premium income or using options to establish a position in a particular commodity, index or interest rate.
As hedging instruments, options can produce offsetting gains in the face of adverse price changes in the cash market.
Options permit you to efficiently deploy capital, in the form of option premium. In this case, you can participate in the price movements of the underlying asset, without having to buy the asset outright.
So when it comes to options on futures, both buyers and sellers have an array of choices to efficiently deploy their capital, while expressing their opinion or managing their price risk in the marketplace.