Futures options refer to a contract that grants the holders a right to buy or sell, a commodity or stock, for a specified price at a future date. On that future date, the contract is exercised; the buyer pays the seller for the commodity or stock at the previously set price, independent of the market-value price. Oil future options refer to the buying and selling of barrels of oil, crude and heating, but also refers to gallons of gasoline.
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Future Options are Contracts
Future options are legally binding contracts in which money is exchanged in fulfillment of the contract; in this case the purchase and sale of oil at some specified future date. A put option is the right to sell the oil at a specified price; a call option is the right to buy the oil at a specified price; and the specified price is called the strike price. Oil future options attempt to predict the rise and fall of the price of oil which is dependent on supply and demand.
The writer of the future options contract is generally the seller. The contract includes the options type, put or call, the strike price and the expiration date along with the quantity of the oil and the multiplier, for example 1,000 barrels, or BBL, to be purchased at $73/BBL. The contract also specifies how it will be settled when exercised and it is usually a cash transaction.
Purpose of Oil Future Options
Oil future options are useful to businesses, especially manufacturers, which have consistent demand for oil and need to lock in stable prices over time so that business processes can run and profit independent of commodity price swings. For example, a steel producer uses a lot of crude oil to meet its energy needs over its budget year, but can only profit when oil is priced below $80/BBL; a call option throughout the year to buy oil below $80/BBL is necessary for this business to be profitable.
Oil future options also can be used to make money if you predict future oil prices correctly. If you have a call option to buy oil at $68/BBL and at the time the option is exercised the market price of oil is $77/BBL, you can buy the oil at $68 and sell it at $77/BBL on the open market, the New York Mercantile Exchange, making a $9 profit.
Risks of Oil Future Options
There are significant risks associated with oil future options. If you have a call option to buy oil at $68/BBL and the market value is $48/BBL on the expiration date, you would lose money, $20/BBL, on the open market. The futures option is a contract and generally is fulfilled with a cash transaction on the expiration date. Cash must be available to cover call options; oil must be available to cover put options.
Risks are associated with price predictions as a warm winter could drive oil demand down and a call option could set a high strike price during the winter months.
Benefits of Future Options
Oil prices can fluctuate wildly. Besides weather, oil prices are affected by the costs of extraction, import and export as well as government policies and national security. Any entity that relies on oil as its energy source needs to have a reliable expectation of price in order to budget properly.
Even homeowners benefit theoretically from oil future options although not on commodity exchanges. If heating oil prices are expected to rise in the winter months, some oil providers will allow you to pay a fixed monthly fee throughout the year instead of just the winter months heating oil price. For instance, a homeowner would pay $175 each of the 12 months in a year equaling $2,100 for their annual heating bill as opposed to $600 for the four months of winter when oil demand, and prices, are high (November, December, January, and February), which would turn out to be $2,400 for their annual heating bill. Benefits include homeowner savings and the oil supplier gets a consistent cash flow throughout the year allowing for business to run smoothly.
Oil future options traders operate in the same way by bringing high volume buyers and sellers together to alleviate losses due to large price swings.
Conditions of Oil Future Options
It is important to know that the future option is a contract and must be exercised at the strike price no matter what the market value price is at that expiration date of the contract. Oil prices are affected by supply and demand, and influenced by weather; warm weather can decrease demand for heating oil, hurricanes can damage offshore oil drilling platforms decreasing supply. Oil prices may also be affected by the oil futures options market itself when large volumes of options trade in one direction, put or call, and thereby influence the overall market opinion of what future oil prices will be.
