Every option in the commodities markets has different characteristics, depending on how you want to exercise the option and what action you want to conduct when it’s exercised. Put simply, you can use options that allow you to either buy or sell an underlying security. You can further specify at which point you want to exercise the options agreement.
If you expect rising prices, you can buy a call option that gives you the right — but not the obligation — to purchase a specific amount of a security at a specific price at a specific point in the future.
When you buy a call option, you’re being bullish and are expecting prices to increase — call options are similar to having a long position.
When you sell a call option, you expect prices to fall. If the prices fall and never reach the strike price, you get to keep the premium. If prices increase and the holder exercises her option, you’re obligated to sell her the underlying asset at the agreed-upon price.
Put options: Putting everything on the line
A put option is the exact opposite of a call option because it gives you the right, but not the obligation, to sell a security at some point in the future for a predetermined price. When you think the price of a security is going down, you want to use a put option to try to take advantage of this price movement.
Buying a put option is one way of shorting a security. If prices do decrease, you can purchase the security at the agreed-upon (lower) price and then turn back and sell it on the open market, pocketing the difference. On the other hand, if prices increase, you can choose to let the option expire. In this case, you lose only the premium you paid for the option.
When you sell a put option, you believe that prices are going to increase. If you’re correct and prices increase, the holder won’t exercise the option, which means you get to collect the premium. So when you sell a put option, you’re actually being bullish.
Here are the possible combinations of buying and selling put and call options, accompanied by their corresponding market sentiment:
Buying a call: Bullish
Selling a call: Bearish
Buying a put: Bearish
Selling a put: Bullish
Looking at American options
When you buy an American option, you have the right to exercise that option at any time during the life of the option — from the start of the option until the expiration date. Most options traded in the United States are American options. You get a lot more flexibility out of them because you have the freedom to exercise them at any point.
Taking the European alternative
The European option allows you to exercise the option only at expiration. This is a fairly rigid kind of option. The only possible advantage of a European option over an American option is that you may be able to pay a smaller premium for this option. However, because of its rigidity, it is safer to use American options in your trading strategies.