Options on Futures

Learn about what Options on Futures are, how they work in conjunction with futures and how you can profit from them.

Options on Futures - Definition

Options on Futures are options with futures contracts as their underlying asset.

Options on Futures - Introduction

Options are options, Futures are futures, so what are Options on Futures?

Options on Futures, also known as "Futures Options", is an unique form of derivative instrument as it is a "Derivative on Derivative", which is a derivative instrument coming out of another derivative instrument rather than an equity or commodity asset. Normally, derivative instruments are based on and derive their value from an asset such as stocks or commodities. Such derivative instruments include options and futures. However, Options on Futures are options that derive their value from another derivative instrument, Futures, which in turn derive their value from an underlying asset such as an index or commodity.

What are Options on Futures?

Stock options are options with stocks as their underlying asset. When stock options are exercised, shares of the underlying stock exchange hands between the long and short. Similarly, Options on Futures are simply options with futures contracts as their underlying asset. Options on Futures are created when futures are created for the trading of an asset and then options are created to trade those futures contracts at specific strike prices.

When Options on Futures are exercised, futures contracts exchange hands between the long and the short and when the resultant futures contract expires, the underlying asset is traded between the long and the short of the futures contracts if it is a physically settled futures contract and if it is a cash settled futures contract, the long and the short of the resultant futures contract simply settle their wins and losses in cash.

It is recommended for you to have a complete knowledge and some experience in futures trading before attempting to trade Options on Futures. Learn everything about Futures Trading.

How Does Options on Futures Work?

Options on Futures work exactly the same way stock options work except for the fact that upon exercised, what you get is a futures position instead of an asset. When you buy a call options on futures, you own the right but not the obligation to buy the underlying futures contract at a fixed price and when you buy a put options on futures, you own the right but not the obligation to short the underlying futures contract at a fixed price.

When a call options on futures is exercised, the buyer of the futures options receives a long position in the underlying futures contract after paying initial margin requirement and a payment in cash equal to the difference between the current futures price of the futures contract and the strike price. This is because a buyer of a call options on futures would only exercise the option when it is In The Money. That is when the strike price of the futures option is lower than the current futures price of the futures contract.

Call Options on Futures Exercise Example Assuming you bought 1 contract of Call S&P500 Futures Options on its March Futures with strike price of 1000. Assuming S&P500 rallies and its March Futures rallies to 1030 points and you decide to exercise your call options and take delivery on the S&P500 March Futures. Assuming SPAN MARGIN requirement of 12%. You receive a long position on 1 contract of S&P500 March Futures bought at 1000 points and pays SPAN initial margin requirement of $30,900 (1030 x 250 x 12%) You also receive cash profit of 1030 - 1000 = 30 x 250 = $7,500 cash.

Conversely, the seller of the call futures options receives a short position in the underlying futures contract after paying initial margin requirement and also pays the long in cash the difference between the prevailing futures price and the strike price.

Call Options on Futures Exercise Example 2 Assuming you Sell To Open (shorted) 1 contract of Call S&P500 Futures Options on its March Futures with strike price of 1000. Assuming S&P500 rallies and its March Futures rallies to 1030 points and the call options on futures is exercised by the buyer of the options contract. Assuming SPAN MARGIN requirement of 12%. You receive a short position on 1 contract of S&P500 March Futures shorted at 1000 points and pays SPAN initial margin requirement of $30,900 (1030 x 250 x 12%) You also pay a cash loss of 1030 - 1000 = 30 x 250 = $7,500 cash.

When a put options on futures is exercised, the buyer of the futures options receives a short position in the underlying futures contract after paying initial margin requirement and a payment in cash equal to the difference between the current futures price of the futures contract and the strike price. This is because a buyer of a put options on futures would only exercise the option when it is in the money. That is when the strike price of the futures option is higher than the current futures price of the futures contract.

Put Options on Futures Exercise Example Assuming you bought 1 contract of Put S&P500 Futures Options on its March Futures with strike price of 1000. Assuming S&P500 drops and its March Futures drops to 970 points and you decide to exercise your put options and take delivery on the S&P500 March Futures. Assuming SPAN MARGIN requirement of 12%. You receive a short position on 1 contract of S&P500 March Futures shorted at 1000 points and pays SPAN initial margin requirement of $29,100 (970 x 250 x 12%). You also receive cash profit of 1000 - 970 = 30 x 250 = $7,500 cash.

Conversely, the seller of the put futures options receives a long position in the underlying futures contract after paying initial margin requirement and also pays the short in cash the difference between the prevailing futures price and the strike price.

Put Options on Futures Exercise Example 2 Assuming you Sell To Open (shorted) 1 contract of Put S&P500 Futures Options on its March Futures with strike price of 1000. Assuming S&P500 drops and its March Futures drops to 970 points and your short put options were exercised by the buyer. Assuming SPAN MARGIN requirement of 12%. You receive a long position on 1 contract of S&P500 March Futures bought at 1000 points and pays SPAN initial margin requirement of $29,100 (970 x 250 x 12%). You also pay in cash a loss of 1000 - 970 = 30 x 250 = $7,500 cash.

Initial margin for the underlying futures position would need to be paid according to the prevailing futures price upon exercise in order to take delivery on the underlying futures.

As Options on Futures are options based on futures contracts and not the underlying asset behind that futures contract, traders of Options on Futures are really speculating on the price of the futures contracts instead of the price of the underlying asset behind that futures contract. This is because futures prices do not usually move in tandem or at the same price as their underlying asset before expiration. As in the examples above, when you trade an S&P500 Futures Options on its March Futures, you are speculating and profiting from the price movement of the March Futures and not the S&P500 index itself. In fact, futures prices and the price of their underlying asset can sometimes move in opposite directions! This is why it is important to have a solid fundamental knowledge in futures trading before attempting to trade Options on Futures.

As such, you should be buying Call Options on Futures when your outlook on the futures price of a particular futures contract is sustained bullish and shorting Call Options on Futures when your outlook is moderately bearish. Conversely, you should be buying Put Options on Futures when your outlook on the futures price of a particular futures contract is sustained bearish and shorting Put Options on Futures when your outlook is moderately bullish (Read more about the Six Different Outlooks In Options Trading). This also means that you can perform all kinds of options strategies using Options on Futures. This is particularly useful for commodities that do not have options offered on them directly.

Types of Options on Futures

Just like stock options, Options on Futures comes in both European Style Options as well as American Style Options. European Style Options on Futures can only be exercised upon expiration if the options are in the money while American Style Options on Futures can be exercised for the underlying futures contract at anytime prior to expiration.

On top of these two broad categories, there are also Options on Physically Delivered Futures as well as Options on Cash-Settled Futures. Options on Physically Delivered Futures are options written on futures contracts that ultimately end with the trading of the physical commodity behind the futures contract while Options on Cash-Settled Futures are options written on futures contracts that ultimately end with the settling of wins and losses in cash between the long and the short without any trading of the underlying commodity. Almost all commodities have both physically delivered as well as cash-settled futures contracts and with both European Style Options and American Style Options available on both kinds of futures contracts in the form of both call and put options, the tree of derivative instrument behind a single commodity can be really huge.

Based on the kind of futures contracts the options are written on, Options on Futures are also known according to the type of futures. Some examples are; Options on Index Futures, Options on Forex Futures, Options on Commodities Futures etc.

Why Options on Futures?

The most obvious reason for the use of Options on Futures is when an asset has no options available for trading but only futures and Options on Futures. In this case, trading Options on Futures is the closest one can get to trading options on the underlying asset itself. However, in today's comprehensive derivatives market, there are options available directly for trading on most assets.

Since there are options available directly on most assets, why should Options on Futures be traded? Apart from being a price speculation tool, one of the most important use for Options on Futures is for hedging against futures positions. Futures positions comes with unlimited risk which can easily go into a margin call if one is not careful. In fact, whole multinational coorporations and banks have collapsed from careless futures trading. By hedging existing futures positions with options on futures, one could limit one's futures trading risk exposure greatly.

Some Options on Futures such as those traded on the Chicago Mercantile Exchange, CME, actually trades around the clock providing a 24hours centralised global marketplace. This 24hours market is a benefit missing in plain vanilla stock options.

Hedging Futures with Options on Futures

Indeed, hedging futures positions with Options on Futures is one of the most important usage for Options on Futures. Depending on your specific futures position, there are a few simple ways to hedge using Options on Futures.

When You Are Long Futures

When you are long futures and you wish to completely protect your futures position from any downside risk beyond a certain price, you can simply buy Put Options on Futures for that futures contract at the specific strike price. This is known as a "Protective Put" options strategy. Using this options on futures strategy, you will completely hedge against any price declines below the strike price of the put futures options. However, if you are only expecting a small decline in the price of the futures position, you could hedge the position by shorting at the money or slightly out of the money call options on futures. This is known as a "Covered Call". When writing call futures options against your futures position, the premium received from the sale offsets slightly any decline in price of the futures position as long as the futures price remain below the strike price. However, if the futures price rises above the strike price, your futures position may be called away if the call options are exercised by the buyer.

When You Are Short Futures

when you are short futures and you wish to completely protect your futures position from any upside risk beyond a certain price, you can simply buy call options on futures for that futures contract at the specific strike price. This is known as a "Protective Call" options strategy. Using this options on futures strategy, you will completely hedge against any price rallies above the strike price of the call futures options. However, if you are only expecting a small increase in the price of the futures position, you could hedge the position by shorting at the money or slightly out of the money put options on futures. This is known as a "Covered Put". When writing put futures options against your futures position, the premium received from the sale offsets slightly any increase in price of the futures position as long as the futures price remain above the strike price. However, if the futures price falls below the strike price, your futures position may be called away if the put options are exercised by the buyer.