What Are Options On Futures?
An option on a futures contract gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a strike price on or before the option's expiration date. These work similarly to stock options, but differ in that the underlying security is a futures contract.
Most options on futures, such as index options, are cash settled. They also tend to be European-style options, which means that these options cannot be exercised early.
- Options on futures work similarly to options on other securities (such as stocks), but they tend to be cash settled and of European style, meaning no early exercise.
- Futures options can be thought of as a 'second derivative' and require the trader to pay attention to detail.
- The key details for options on futures are the contract specifications for both the option contract and the underlying futures contract.
How Options On Futures Work
An option on a futures contract is very similar to a stock option in that it gives the buyer the right, but not obligation, to buy or sell the underlying asset, while creating a potential obligation for the seller of the option to buy or sell the underlying asset if the buyer so desires by exercising that option. That means the option on a futures contract, or futures option, is a derivative security of a derivative security. But the pricing and contract specifications of these options does not necessarily add leverage on top of leverage.
An option on an S&P 500 futures contract, therefore, can be though of as a second derivative of the S&P 500 index since the futures are themselves derivatives of the index. As such, there are more variables to consider as both the option and the futures contract have expiration dates and their own supply and demand profiles. Time decay (also known as theta), works on options futures the same as options on other securities, so traders must account for this dynamic.
For call options on futures, the holder of the option would enter into the long side of the contract and would buy the underlying asset at the option's strike price. For put options, the holder of the option would enter into the short side of the contract and would sell the underlying asset at the option's strike price.
Example of Options on Futures
As an example of how these option contracts work, first consider an S&P 500 futures contract. The most popularly traded S&P 500 contract is called the E-mini S&P 500, and it allows a buyer to control an amount of cash worth 50 times the value of the S&P 500 Index. So if the value of the index were to be $3,000, this e-mini contract would control the value of $150,000 in cash. If the value of the index increased by one percent to $3030, then the controlled cash would be worth $151,500. The difference here would be a $1,500 increase. Since the margin requirements to trade this futures contract are $6,300 (as of this writing), this increase would amount to a 25% gain.
But rather than tie up $6,300 in cash, buying an option on the index would be significantly less expensive. For example, when the index is priced at $3,000, suppose also that an option with the strike price of $3,010 might be quoted at $17.00 with two weeks before expiration. A buyer of this option would not need to put up the $6,300 in margin maintenance, but would only have to pay the option price. This price is $50 times every dollar spent (the same multiplier as the index). That means the the price of the option is $850 plus commissions and fees, about 85% less money tied up compared to the futures contract.
So although the option moves with the same degree of leverage ($50 for every $1 of the index), the leverage in the amount of cash used may be significantly greater. Were the index to rise to $3030 in a single day, as mentioned in a previous example, the price of the option could rise from $17.00, to $32.00. This would imply an increase of $750 in value, less than the gain on the futures contract alone, but compared to the $850 risked, it would represent an 88% increase instead of a 25% increase for the same amount of movement on the underlying index. In this way, depending on which option strike you buy, the money traded may or may not be leveraged to a greater extent than with the futures alone.
Further Considerations for Options on Futures
As mentioned, there are many moving parts to consider when valuing an option on a futures contract. One of them is the fair value of the futures contract compared to cash or the spot price of the underlying asset. The difference is called the premium on the futures contract.
However, options allow the owner to control a large amount of the underlying asset with a smaller amount of money thanks to superior margin rules (known as SPAN margin). This provides additional leverage and profit potential. But with the potential for profit comes the potential for loss up to the full amount of the options contract purchased.
The key difference between futures and stock options is the change in underlying value represented by changes in the stock option price. A $1 change in a stock option is equivalent to $1 (per share), which is uniform for all stocks. Using the example of e-mini S&P 500 futures, a $1 change in price is worth $50 for each contract bought. This amount is not uniform for all futures and futures options markets. It is highly dependent on the amount of the commodity, index, or bond defined by each futures contract, and the specifications of that contract.