What Are Options On Futures?
Options on futures enable Traders to purchase and sell underlying futures contracts at a predetermined (strike) price on or before their expiration. The Contract holder enjoys the right to trade futures, but it never becomes an obligation.
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The concept is similar to trading an asset or stock option, given the expected price rise or the risks to be hedged. The premium is the difference between the fair value of the futures contract and the spot price of the underlying asset.
Options On Futures Explained
In options on futures trading, the trader can buy (exercise a long position) or sell (exercise a short position) the underlying asset. It does not obligate or legally bind them in any way. However, if another party chooses to use its right, the other party must comply with the terms of the agreement. These contracts include stocks, interest rates, equity indexes, commodities, currency pairs, and other assets. Options on futures have supported the growth of the options market, making the major U.S. futures contracts available as options contracts.
Options on futures trading contracts are booked at a predetermined price, much like a conventional futures contract, at which traders will have to purchase or sell the contract. The seller is obligated to settle the contract if the market price of the commodity or asset in question increases and the buyer wishes to acquire it at the predetermined cost, which is less than the current value. Similarly, if the market price of the asset in issue declines and the seller wishes to sell it at a specified price higher than the current value, the buyer must abide by the options on the futures contract.
Buying options on futures pricing will mean that the prospective buyer and seller will be aware of the commodity or asset in question and the futures contract’s expiration date. These contracts become active when the buyer of the options pays the option seller an option premium, providing both parties the opportunity to buy or sell their chosen options at a predetermined price later. These options can be settled in cash, like index options, or they cannot be exercised early like European options.
History
Futures options came into existence in 1982 to provide traders with alternatives to buying futures contracts. The Chicago Board of Trade (CBOT) introduced the trading option for T-bond futures. The Chicago Mercantile Exchange (CME) launched its Index and Options Market division for stock index futures, Eurodollar, and T-bill futures options.
Put Option & Call Option
Contract options are of two types based on the type of right the parties exercise – Call and Put. The former gives the seller the right, but does not obligate, to sell the futures contract at a specific price within a specific period. In contrast, the latter gives the buyer the right, but does not obligate, to buy the futures contract at a predetermined cost within a specific time. The sale happens when a commodity is put up for sale in the market. In contrast, purchasing occurs when a commodity is called from the market.
When traders exercise a call option, they go long, buying the underlying future from the options seller at the strike price on or before the expiration date. On the other hand, when a put option is exercised, the trader goes short and sells the options to the buyer on or before the expiration date at the same strike price.
- The strike price is determined concerning the current price of the underlying future contract.
- When the strike price is less than the futures contract price, it is In-the-Money (ITM) call, else In-the-Money (ITM) put.
- Likewise, when the strike price is the same as the futures price, it could be At-the-Money (ATM) call or At-the-Money (ATM) put.
- When the strike price is more than the futures price, it is the Out-of-the-Money (OTM) call or the Out-of-the-Money (OTM).
Benefits
Options on futures contracts offer multiple benefits to traders, such as:
- First, it can be used as an insurance scheme to avoid future losses predicted due to the expected price fluctuations in the market.
- Help traders keep off from speculated losses. For example, if a trader knows the price of a commodity will rise on a future date, booking options on futures deal at a predetermined price that is less would be a great idea to be on the safer side.
- Allow traders to hedge risks because of adverse price fluctuations in the market.
- Capital deployment is easier with option premium payment to options sellers. This way, traders can manage the price changes by already booking deals at lower costs without buying the assets on the spot.
Example
Let us consider the following options on futures example below for a better understanding:
If an underlying E-mini future of S&P 500 is trading at $1,890 and the strike price call option is $1,870, the trader gets the right to go long for the deal given the profit of $20 on buying.
If an underlying E-mini future on S&P 500 trades at $1,850 and the strike price option is $1,870, the trader gets the right to go short for the deal, given the profit of $20 on putting the asset in the market for sale.
Frequently Asked Questions (FAQs)
Options on futures allow traders to buy (exercise a long position) or sell (exercise a short position) the underlying asset, but they are not required. These options, like index options, can be settled in cash, but they cannot be exercised early like European-style options. Futures contract options include stocks, interest rates, equity indexes, commodities, currency pairs, and other assets.
Options on futures contracts are traded at a predetermined price, similar to a traditional futures contract, at which traders must buy or sell the contract. For example, if the market price of the commodity or asset increases and the buyer intends to acquire it at the predetermined cost, which is less than the current value, the seller must settle the contract. Similarly, if the market price of the asset falls and the seller intends to sell it at a greater price than the current value, the buyer must comply with the futures contract choices.
• These can be used as insurance plans to prevent future losses due to expected market price volatility.
• These aid traders in avoiding speculative losses.
• Traders can manage price swings by already booking deals at reduced prices without buying assets on the spot, allowing them to hedge risks associated with market price movements.
Recommended Articles
This article has been a guide to Options On Futures & its Meaning. Here we discuss its benefits & explanation with put and call options and examples. You can learn more from the following articles –
- Rho in Options
- Currency Options
- Bermuda Options
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
