A futures option, also known as an options on futures, is a type of option where the underlying asset is a specific futures contract. This means that the holder has the right, but not the obligation, to buy or sell a particular futures contract within an agreed-upon period and gain the associated rights and obligations.
Key Principles of Futures Options
Many exchanges that trade derivative contracts offer these options on a large portion of their outstanding futures contracts. In the United States, popular futures options include those on Treasury bonds, grains, soybeans, livestock, gold, and some currencies.
The seller of this option takes on the obligation to buy or sell a futures contract. The expiration date of the futures should occur shortly after the delivery date of the option contract (e.g., two weeks later). The buyer pays the seller a premium, with the exchange’s clearing house acting as the guarantor.
As a result, if the holder of a call option wishes to exercise it, they receive the difference between the strike price of the option and the current price of the futures contract. Typically, the premiums for futures options and options on the underlying asset of the futures contract are the same (if the futures and option have the same expiration date).
Futures Call and Put Options
On Western exchanges, call and put options exist for futures contracts. Any investor can be either a buyer or a seller (writer) of call and put options on futures contracts.
Example of a Futures Call Option
If a call option on a futures contract is exercised, the writer of the option must deliver the specified number of futures contracts to the buyer. After this, the seller automatically takes a short position in futures, while the buyer receives a long position in these futures.
For example, a call option is purchased on a May corn futures contract with a strike price of $3 per bushel. The contract size is 5,000 bushels. The total strike price is 5,000 * $3 = $15,000.
The buyer pays a premium set by the seller (e.g., $0.095 per bushel, totaling $475). If the buyer decides to exercise the option later, the writer of the futures option must deliver the May corn futures contract at the strike price of $3. Clearly, the buyer is not obligated to exercise the option, which reduces their risk in case of adverse price movements.
If the futures contracts are sold on the market for $4 per bushel at the time of exercise, a settlement occurs through cash payments. The seller pays the difference of $1 per bushel or $5,000.
Potential loss for the seller = $5,000 – $475 (premium) = $4,525. Profit for the buyer = $5,000 – $475 = $4,525 (excluding commissions).
Example of a Futures Put Option
If a put option on a futures contract is exercised, the writer must accept the delivery of the corresponding futures contracts from the holder of the futures option. That means the seller must take a long position in the futures contract (buying the futures in exchange for a short position in the option). The holder of the option takes a short position in the futures contract (selling the futures in exchange for a long position in the option). Thus, when a futures put option is exercised, the writer becomes the holder of the futures contract, and the option holder becomes the writer of the futures contract, both taking on the obligations of the futures contract.
For example, a futures put option is purchased on a May corn futures contract with a strike price of $3 per bushel or a total of $15,000. A premium of $0.1575 per bushel or $787.50 is paid to the option writer.
If the option holder decides to exercise the option later, the writer must accept the delivery of the May futures contract at the same strike price. If the option is not exercised, the owner’s loss will be the amount paid to the writer as a premium ($787.50). At the expiration of the futures contract, a settlement must occur between the participants of these positions.
Most futures options are not exercised; instead, reverse trades are often made before the expiration date. Either party can make a reverse trade at any time before the option’s expiration. Even after the option is exercised and a corresponding futures position is opened, an offsetting trade can be made on the futures market.
Thus, for the same underlying asset, options, futures, and futures options can coexist simultaneously.
FAQ
What is a futures option?
A futures option is a contract that gives the holder the right, but not the obligation, to buy or sell a futures contract at a specified price within a certain timeframe.
How do futures options work?
Futures options function similarly to regular options, but the underlying asset is a futures contract. The buyer pays a premium, and the seller takes on the obligation to fulfill the contract if it is exercised.
What are the benefits of trading futures options?
Futures options provide flexibility for traders to hedge against price fluctuations or speculate on future price movements. They also allow for risk management through the use of premiums and expiration dates.
