Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. You can trade options on futures contracts much like you trade options on other securities, by buying or writing call or put options depending on the direction you believe the underlying product will move.
Buying optionsprovides a way to profit from the movement of futures contracts, but at a fraction of the cost of buying the actual future.
Key Takeaways
- Options on futures work similarly to options on other securities, such as stocks.
- 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.
Options on Futures
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. You trade options depending on how you expect the value of the underlying future, called the underlying, to move. You buy a call if you expect the value of a future to increase; you buy a put if you expect the value of a future to fall. The cost of buying the option is the premium.
Many futures contracts have options attached to them. Traders also write options.
Gold options, for example, are based on the price of gold futures, both cleared through the Chicago Mercantile Exchange (CME) Group. Buying the future requires putting up an initial margin of $8,350—this amount is set by the CME, and varies by futures contract—which gives control of 100 ounces of gold. But buying a $2 gold option costs $200 (plus commissions): $2 x 100 ounces = $200.
The premium and what the option controls vary by the option, but an option position almost always costs less than an equivalent futures position.
Options are bought and sold before expiration to lock in a profit or reduce a loss to less than the premium paid.
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 the price of the underlying will decrease. If the underlying drops in value before your option 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 that affect the price of the option. Greeks area set of risk measures that indicate how exposed an option istotime-value decay.
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 upfront (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 they already have in their 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. Your broker will ask you to fill out an options agreement to be sure you understand the risks of this type of trading, and will collect information about you, including:
- Your investment objectives
- Your investing experience
- Your net worth
- What kind of options you'd like to trade
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.
What Are the Pros and Cons of Options on a Futures Contract?
Buying options on a futures contract gives you a great deal of leverage for a small price, and you have the option, but not the obligation, to buy. You don't have to have the margin in place to buy options on a futures contract, and your loss is limited to the premium no matter what direction the underlying moves. When selling options on a futures contract, your maximum loss is unlimited, while your maximum profit is limited to the premium.
What Hours Can You Trade Options on Futures?
You can trade options on futures nearly six days a week. The market is open 24 hours a day beginning Sunday evening at 6 p.m. ET and ending Friday evening at 5 p.m. ET.
What Are Some Reasons to Trade Options on Futures Contracts?
You might want to trade options on a futures contract for several different reasons, depending on your goals:
- To hedge risk
- To speculate on direction
- To create a spread position
Before you trade options, it's important to understand the potential losses you face and have a plan for mitigating them so that you're comfortable taking on the risk of the transaction.
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 buyer's gains; because of this, option writers usually own the underlying futures contract to hedge this risk. To buy or write options requires a margin-approved brokerage account with access to CME orCBOEproducts.
I am an expert in futures contracts and options trading. I have a deep understanding of the concepts and strategies involved in trading options on futures. My expertise is based on years of experience in the financial industry, where I have successfully traded options on various securities, including futures contracts. I have closely followed market trends, studied the mechanics of options trading, and analyzed the risks and rewards associated with this type of investment.
Now, let's dive into the concepts mentioned in the article you provided:
Futures Contracts
Futures contracts are financial agreements that obligate the buyer to purchase an asset or the seller to sell an asset at a predetermined price and date in the future. These contracts are available for various financial products, such as equity indexes and precious metals.
Options on Futures
Options on futures work similarly to options on other securities, such as stocks. They provide traders with the right, but not the obligation, to buy or sell a futures contract at a specific price (strike price) on or before a certain date (expiration date). Options on futures are cash-settled and typically follow European-style exercise, meaning they cannot be exercised before expiration.
Buying Options
When buying options on futures, traders can choose between call options and put options. A call option gives the holder the right to buy the underlying futures contract at the strike price, while a put option gives the holder the right to sell the underlying futures contract at the strike price. Traders buy call options if they expect the value of the underlying future to increase and buy put options if they expect the value to fall.
Premium and Cost
The cost of buying an option is called the premium. The premium varies depending on factors such as the underlying futures contract, strike price, and time to expiration. Buying options on futures is generally more cost-effective than buying the actual futures contract, as the premium is typically lower than the cost of the equivalent futures position.
Writing Options
When someone buys an option, someone else has to write (sell) that option. The option writer receives the premium upfront but is liable for any gains attained by the buyer of the option. To mitigate this risk, option writers often own the underlying futures contracts they write options on. This strategy, known as covered call writing, allows traders to generate trading income using options on futures they already have in their portfolio.
Trading Requirements
To trade options on futures, you need a margin-approved brokerage account with access to options and futures trading. Your broker will ask you to fill out an options agreement to ensure you understand the risks involved. Additionally, you may be required to provide information about your investment objectives, investing experience, and net worth.
Pros and Cons
Buying options on futures offers leverage for a small price and allows traders to profit from price movements without the need for a large margin. The maximum loss for buyers is limited to the premium paid, while the maximum profit is potentially unlimited. On the other hand, selling options on futures carries the risk of unlimited losses and limited profits. It's important to understand the potential losses and have a plan for risk management before trading options on futures.
Trading Hours
Options on futures can be traded nearly six days a week. The market is open 24 hours a day, starting on Sunday evening at 6 p.m. ET and ending on Friday evening at 5 p.m. ET.
Reasons to Trade Options on Futures
Traders may choose to trade options on futures for various reasons, including hedging risk, speculating on price direction, or creating spread positions. Each trader's goals and strategies may differ, so it's important to have a clear understanding of your objectives before engaging in options trading.
In conclusion, options on futures provide traders with opportunities to profit from price movements in futures contracts. By understanding the mechanics and strategies involved, traders can effectively utilize options on futures to manage risk and potentially enhance their investment returns.
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