Trading Options on Futures Contracts

By Cory Mitchell | September 02, 2014 AAA

Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying or writing call or put options depending on the direction you believe an underlying product will move. (For more on how to decide which call or put option to use, see "Which Vertical Option Spread Should You Use?") 

Buying options provides a way to profit from the movement of futures contracts, but at a fraction of the cost of buying the actual future. Buy a call if you expect the value of a future to increase. Buy a put if you expect the value of a future to fall. The cost of buying the option is the premium. Traders also write options.

Options on Futures

Many futures contracts have options attached to the them. Gold options, for example, are based on the price of gold futures (called the underlying), both cleared through the Chicago Mercantile Exchange (CME) Group. Buying the future requires putting up an initial margin of $7,150--this amount is set by the CME, and varies by futures contract--which gives control of 100 ounces of gold. Buying a $2 gold option, for example, only costs $2 x 100 ounces = $200, called the premium (plus commissions). The premium and what the option controls varies by the option, but an option position almost always costs less than an equivalent futures position. (For insight on how gold prices are set, see "The Insiders Who Fix Rates for Gold, Currencies, and Libor") 

Buy a call option if you believe the price of the underlying will increase. If the underlying increases in price before the option expires, the value of your option will rise. If the value doesn't increase, you lose the premium paid for the option.

Buy a put option if you believe of the underlying will decrease. If the underlying drops in value before your options expires, your option will increase in value. If the underlying doesn't drop, you lose the premium paid for the option.

Option prices are also based on 'Greeks,' variables which affect the price of the option. Greeks are a set of risk measures that indicate how exposed an option is to time-value decay.

Options are bought and sold before expiration to lock in a profit or reduce a loss to less than the premium paid. 

Writing Options for Income

When someone buys an option, someone else had to write that option. The writer of the option, who can be anyone, receives the premium from the buyer up front (income) but is then liable to cover the gains attained by the buyer of that option. The option writer's profit is limited to the premium received, but liability is large since the buyer of the option is expecting the option to increase in value. Therefore, option writers typically own the underlying futures contracts they write options on. This hedges the potential loss of writing the option, and the writer pockets the premium. This process is called "covered call writing" and is a way for a trader to generate trading income using options, on futures she already has in her portfolio.  

A written option can be closed out at any time, to lock in a portion of the premium or limit a loss.

Trading Options Requirements

To trade options you need a margin approved brokerage account with access to options and futures trading. Options on futures quotes are available from the CME (CME) and the Chicago Board Options Exchange (CBOE), where options and futures trade. You can also find quotes in the trading platform provided by options brokers. 

The Bottom Line

Buying options on futures may have certain advantages over buying regular futures. The option writer receives the premium upfront but is liable for the buyers gains; because of this, option writers usually own the own the underlying futures contract to hedge this risk. To buy or write options requires a margin approved brokerage account with access to CME and/or CBOE products.  

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