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.
