If you've ever studied a second language, you know how hard it can be. But once you learn, say, Spanish as a second language - learning Italian as a third would be much easier since both have common Latin roots. To get facility with Italian as a third language, you would need only to grasp minor changes in word forms and syntax. Well, the same could be said for learning options. (To learn the basics, read our Options Basics Tutorial.)

For most people, learning about stock options is like learning to speak a new language, which requires wrestling with totally unfamiliar terms. But if you already have some experience with stock options, understanding the language of options on futures becomes easy. In fact, basic concepts such as delta, time value and strike price apply the same way to futures options as to stock options, except for slight variations in product specifications, essentially the only hurdle to get passed.

In this article, we provide an introduction to the world of S&P 500 futures options that will reveal to you how easy it is to make the transition to options on futures (also known as commodity or futures options), where a world of potential profit awaits.

Stock Index Options on Futures
The first thing that probably throws a curve ball at you when initially approaching options on futures is that you may not be familiar with a futures contract, the underlying instrument upon which options on futures trade. Recall that for stock options, the underlying is the equity issue (e.g. IBM call options trade on IBM stock). Since most investors understand how to interpret stock prices, figuring out the underlying is easy.

When learning futures options, on the other hand, traders new to any particular market (bonds, gold, soybeans, coffee or the S&Ps) need to get familiar not only with the option specifications but also with the product specifications of the underlying futures contract. These, however, are insignificant obstacles in today's online environment, which offers so much information just a click away. This article will hopefully interest you in exploring these exciting markets and new trading opportunities. (For more background knowledge, read Understanding Option Pricing.)

S&P Options on Futures
To illustrate how options on futures work, I will explain the basic characteristics of S&P 500 options on futures, which are the more popular in the world of futures options. Although these are cash-based futures options (i.e. they automatically settle in cash at expiration), the logic of S&P futures options, like all futures options, is the same as that of stock options. S&P 500 futures options, however, offer unique advantages; for example, they can allow you to trade with superior margin rules (known as SPAN margin), which allow more efficient use of your trading capital.

Perhaps the easiest way to begin getting a feel for options on futures is simply to look at a quotes table of the prices of S&P 500 futures and the prices of the corresponding options on futures. Essentially, the principle of the pricing of S&P futures is the same as that of the price behavior of any stock. You want to buy low and sell high. In other words, if the S&P futures rise, the value of the contract rises and vice versa if the price of S&P futures fall.

Important Differences and Characteristics
There is, however, a key difference between futures and stock options. A $1 change in a stock option is equivalent to $1 (per share), which is uniform for all stocks. With S&P futures, a $1 change in price is worth $250 (per contract), and this is not uniform for all futures and futures options markets. While there are other issues to get familiar with - such as the fair value of S&P futures and the premium on the futures contract - these related concepts are insignificant in practice and for what you need to understand for most option strategies.

Aside from the distinction of price specification, there are some other important characteristics of S&P options that are important. Since these options trade on the underlying futures, the level of S&P futures, not the S&P 500 stock index, is the key factor affecting prices of options on S&P futures. Volatility and time-value decay also play their part, just like they affect a stock option.

Let's take a closer look at S&P futures and option prices, particularly at how changes in the price of futures affect changes in the prices of the option. First let's look at S&P futures product specifications, which are presented in Figure 1.

Futures Contract Contract Value Tick Size Delivery Months Last Trading Day Type of Settlement
S&P 500 $250 x price of S&P 500 .10 (a \'dime\') = $25 March, June, Sept. and Dec. Thursday prior to the third Friday of the contract month Cash
Figure 1- S&P Futures Product Specifications

S&P futures trade in "dime-sized" ticks (the minimum price change intervals), worth $25 each, so a full point ($1) is equal to $250. The active month is known as the "front-month contract", and it is the first of the three delivery months listed in Figure 2. The last trading day for all S&P futures contracts is on the Thursday before expiration, which is on the third Friday of the contract month. By looking at Figure 2 below, we can see some actual prices for the S&P 500 futures, taken from the close of daily trading (pit-session) on Jun 12, 2002.

Contract High Low Settlement Point Change
June \'02 1022.80 1002.50 1020.20 +6.00
Sept. \'02 1023.80 1003.50 1021.20 +6.00
Dec. \'02 1025.00 1007.00 1023.00 +6.00
Figure 2 - Settlement prices for June 12, 2002

The Jun S&P futures contract in Figure 2, for example, settled at 1020.20 on this particular day. The point change of +6.00 is equivalent to a gain of $1,500 per single contract (6 x $250 = $1,500). It is worth noting that the S&P futures and the S&P 500 stock index will trade nearly identically, but the S&P futures will trade with a slight premium attached.

Understanding S&P Futures Options
Now let's turn to some of the corresponding options. Like for nearly all options on futures, there is a uniformity of pricing between the futures and options. That is, the value of a $1 change in premium is the same as a $1 change in the futures price. This makes things easy. In the case of S&P 500 futures options and their underlying futures, a $1 change is worth $250. To provide some real examples of this principle, I have selected in Figure 3 the 25-point interval strike prices of some out-of-the-money puts and calls trading on the Jun S&P futures.

Just as we would expect for stock put and call options, the delta in our examples below is positive for calls and negative for puts. Therefore, since the Jun S&P futures rose by six points (at $250 per point, or dollar), the puts fell in value and the calls rose in value. The strikes farthest from the money (925 put and 1100 call) will have the lower delta values, and those nearest the money (1000 put and 1025 call) have higher delta values. Both the sign and the size of the change in dollar value for each option make this clear. The higher the delta value the greater the option price change will be affected by a change of the underlying S&P futures.

Figure 3 - S&P option prices at settlement on June 12, 2002

For example, we know that the Jun S&P futures rose six points to settle at 1020.20. This settlement price is just shy of the Jun call strike price of 1025, which increased in value by $425. This near-the-money option has a higher delta (delta = 0.40) than options farther from the money, such as the call option with a strike price of 1100 (delta = 0.02), which increased in value by only $12.50. Delta values measure the impact further changes in the underlying S&P futures will have on these option prices. If, for instance, the underlying Jun S&P futures were to rise 10 more points (provided there is no change in time-value decay and volatility), the S&P call option in figure 3 with a strike price of 1025 would rise by four points, or gain $1,000.

The same but reverse logic applies to the S&P put options in Figure 3. Here we see the put option prices declining with a rise in the Jun S&P futures. The nearest-the-money option has a strike price of 1000, and its price fell by $600. Meanwhile, the farther-from-the-money put options, such as the option with a strike price of 925 and delta of -0.04, lost less, a value of $225.

While there are many ways to trade using these options, many traders prefer to be a net seller of options. Whether you prefer to buy or write (sell) stock options using either simple spreads or more complex strategies, you can, with the basics presented here, easily adapt many of your favorite strategies to S&P options on futures. (For more, read How to Profit from Time-Value Decay.)

As for other options on futures markets, you'll need to get familiar with their product specifications - such as trading units and tick sizes - before doing any trading. Having said that, however, I am sure you will find that becoming fluent in a second options language is not as difficult as you might initially have thought.

For further reading, check out Options Hazard That Can Bruise Your Portfolio and Make Better Options Trades.

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