Futures Markets - Part 11: Options on Futures

Futures Trading Short Course

Options on futures began trading in 1983. Today, puts and calls on agricultural, metal, and financial (foreign currency, interest-rate and stock index) futures are traded by open outcry in designated pits. These options pits are usually located near those where the underlying futures trade. Many of the features that apply to stock options apply to futures options.

An option's price, its premium, tracks the price of its underlying futures contract which, in turn, tracks the price of the underlying cash. Therefore, the March T-bond option premium tracks the March T-bond futures price. The December S&P 500 index option follows the December S&P 500 index futures. The May soybean option tracks the May soybean futures contract. Because option prices track futures prices, speculators can use them to take advantage of price changes in the underlying commodity, and hedgers can protect their cash positions with them. Speculators can take outright positions in options. Options can also be used in hedging strategies with futures and cash positions.

Futures options have some unique features and a set of jargon all their own.

Puts, Calls, Strikes, etc.

Futures offer the trader two basic choices - buying or selling a contract. Options offer four choices - buying or writing (selling) a call or put. Whereas the futures buyer and seller both assume obligations, the option writer sells certain rights to the option buyer.

A call grants the buyer the right to buy the underlying futures contract at a fixed price the strike price. A put grants the buyer the right to sell the underlying futures contract at a particular strike price. The call and put writers grant the buyers these rights in return for premium payments which they receive up front.

The buyer of a call is bullish on the underlying futures; the buyer of a put is bearish. The call writer (the term used for the seller of options) feels the underlying futures' price will stay the same or fall; the put writer thinks it will stay the same or rise.

Both puts and calls have finite lives and expire prior to the underlying futures contract.

The price of the option, its premium, represents a small percentage of the underlying value of the futures contract. In a moment, we look at what determines premium values. For now, keep in mind that an option's premium moves along with the price of the underlying futures. This movement is the source of profits and losses for option traders.

Who wins? Who loses?

The buyer of an option can profit greatly if his view is correct and the market continues to rise or fall in the direction he expected. If he is wrong, he cannot lose any more money than the premium he paid up front to the option writer.

Most buyers never exercise their option positions, but liquidate them instead. First of all, they may not want to be in the futures market, since they risk losing a few points before reversing their futures position or putting on a spread. Second, It is often more profitable to reverse an option that still has some time before expiration.

Option Prices

An option's price, its premium, depends on three things: (1) the relationship and distance between the futures price and the strike price; (2) the time to maturity of the option; and (3) the volatility of the underlying futures contract.

The Put

Puts are more or less the mirror image of calls. The put buyer expects the price to go down. Therefore, he pays a premium in the hope that the futures price will drop. If it does, he has two choices: (1) He can close out his long put position at a profit since it will be more valuable; or (2) he can exercise and obtain a profitable short position in the futures contract since the strike price will be higher than the prevailing futures price.

Next Page: Stops, limit orders and trading limits: a Safety Net for Futures Traders
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