Motives for Buying and Selling Options

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