Options on Futures

So, here’s an interesting question.  What happens when you take a derivative of a derivative?  It sounds like either something out of The Big Short or Inception.  But, that’s exactly what options on futures contracts look like.  Most investors or traders have at least some experience with options on stocks.  More advanced traders and investors probably have some experience or understand futures contracts.  Rarely do you find people that are aware of the existence of futures options, let alone trade them.

So What Is The Difference

Let’s start with what an option is.  Options are contracts that give the purchaser the right to buy or sell an underlying asset at a particular price, known as the strike price.  The holder of the contract doesn’t have to exercise the contract, but they can should they choose.  Options are often tied to a stock, like IBM, where the value of the option comes from how close the stock is to the strike price, how much time is left to expiration, as well as how much implied volatility exists (Yes there are other components, but for this discussion we’ll keep it simple).  Options are defined by the bid and ask, the same as any stock, with the exception that each contract contains lots of 100, which means you multiply the price by 100 to get the actual cost.

Futures differ from an option in that they are an obligation to buy or sell an asset at a defined price at a specific time in the future. A buyer of an option doesn’t have an obligation but has a right to buy or sell.  Futures do exist on single stocks, though most people understand them in terms of stock indexes, commodities, or other large quantity or block items.  People often trade futures because of the exceptional leverage they offer and broad exposure.  Leverage depends on the type of contracts purchased (micro, mini or regular), the product itself, and sometimes the broker that it’s traded through.

And Then There Was Futures Options

So reasonably you would expect that options on futures are just that, leverage on a leveraged product?  That’s pretty much it.  You’re essentially taking what was otherwise a leveraged trade on the futures and juicing it up more with the options.  However, the options allow all the flexibility to play various spreads and strategies that are available on stocks that otherwise can’t be achieved through futures contracts.

What’s also important to understand is how these contracts settle (though most traders close them out before settlement).  If the options and the futures expire in the same month they will settle as cash.  However, if the options expire before the futures contract, you settle and are left with a futures contract.  Understanding these differences is key to knowing how much capital you’ll be required to hold should a contract be exercised.

Lastly, it’s worth mentioning that all underlying indexes have a direct relationship with their futures (with the exception of the VIX).  If they didn’t, you could have someone come in and either buy or sell all the underlying assets of that index to create what’s known as index arbitrage.

When To Consider Futures Options

Options on futures provide large amounts of leverage, and offer additional flexibility to investing and trading.  However, they come at a cost of liquidity and some additional complexity.  Trading options on futures can be a great way to achieve leverage.  Yet, those same trades can quickly turn against you if you don’t understand the nuances of how those contracts operate, trade and settle.  If it’s something you haven’t tried before, practice in a demo account before you try it with real funds.