What are futures options?
Options on futures contracts give the holder the right, but not the obligation, to buy or sell a particular futures contract at the strike price on or before the expiration date of the option. They work similarly to stock options, except 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 these options cannot be exercised early.
- Options on futures act like options on other securities, such as stocks, but they tend to be cash-settled and European-style, meaning they are not exercised early.
- Options on futures can be thought of as “secondary derivatives” that require traders to pay attention to details.
- The key detail of options on futures is the contract specification of the options 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 no 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 is willing to exercise that option, the underlying asset. This means that options on futures contracts or options on futures are derivative securities of derivative securities. But the pricing and contract specifications of these options do not necessarily add leverage on top of leverage.
Therefore, options on S&P 500 futures contracts can be considered as second-order derivatives of the S&P 500 index, since the futures are themselves derivatives of the index. Therefore, since options and futures contracts have expiry dates and their own supply and demand conditions, there are more variables to consider. Time decay (also known as theta) acts on options futures in the same way as options on other securities, so traders must account for this dynamic.
For a futures call option, the option holder will go long on the contract and buy the underlying asset at the option’s strike price. For put options, the option holder will take a short position in the contract and sell the underlying asset at the strike price of the option.
Futures Options Example
As an example of how these options contracts work, first consider an S&P 500 futures contract. The most popular S&P 500 contract is called the E-mini S&P 500, which allows buyers to control cash worth 50 times the value of the S&P 500. So, if the value of the index is $3,000, the electronic mini-contract will control the cash value of $150,000. If the value of the index were to increase by 1% to $3,030, the controlled cash would be worth $151,500. The difference here will increase by $1,500. Since the margin requirement to trade this futures contract is $6,300 (as of this writing), this increase would represent a gain of 25%.
But instead of tying up $6,300 in cash, it’s much cheaper to buy index options. For example, when the index is priced at $3,000, it is also assumed that an option with a strike price of $3,010 might be quoted at $17.00 two weeks before expiration. Buyers of this option are not required to pay the $6,300 margin maintenance, but only the option price. This price is $50 per $1 spent (same multiplier as the index). This means that the price of the option is $850 plus commissions and fees, which is about 85% less tied up compared to the futures contract.
So while the options move with the same level of leverage ($50 per $1 on the index), the leverage on the amount of cash used can be much greater. If the index rises to $3030 in one day, as in the previous example, the option price could rise from $17.00 to $32.00. This would mean a $750 increase in value, which is less than the return on the futures contract alone, but compared to the $850 risk, this would represent an 88% increase instead of the same 25% increase in the underlying index. This way, depending on your purchase of the option strike price, the funds being traded may or may not be leveraged to a greater extent than with futures alone.
Further Considerations for Options on Futures
As mentioned earlier, there are many moving parts to consider when valuing options on futures contracts. One of these is the fair value of the futures contract relative to the cash or spot price of the underlying asset. The difference is called the premium of the futures contract.
However, due to superior margin rules (called SPAN margin), options allow the owner to control a large amount of the underlying asset with less capital. This provides additional leverage and profit potential. But with the potential for profit, it is also possible to lose up to the full amount of the option contract purchased.
The main difference between futures and stock options is the change in the underlying value represented by a change in the stock option price. A $1 change in stock options is equivalent to $1 (per share), which is uniform for all stocks. Taking e-mini S&P 500 futures as an example, for every contract bought, a price change of $1 is equivalent to $50. This amount is not uniform for all futures and futures options markets. It is highly dependent on the number of commodities, indices or bonds defined by each futures contract, as well as the specifications of that contract.