What are Options On Futures
For call options, 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.
BREAKING DOWN Options On Futures
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. The difference is that the option of futures, or futures option, is a derivative security of a derivative security.
For example, an option on the Standard & Poor's 500 futures contract is the second derivative of the S&P 500 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.
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. With S&P 500 futures, a $1 change in price is worth $250 (per contract), and this 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.