Futures Options

Options on futures contracts are similar to options on stocks, as they give the buyer the right but not the obligation to purchase a futures contract at a specific price on or before a certain date.  Similar to options on stocks, options on futures are exercised into the futures contract, but they differ in the sense that futures contracts are leveraged investment vehicles that can generate significant risks.

Futures Contracts

A futures contract is an agreement between two parties in which the buyers agrees to receive a commodity in the future and the seller agrees to deliver a commodity at a certain date in the future.

A futures contract is also an investment vehicle that provides the buyer the obligation to purchase a specific underlying asset on a specific data.  Futures contracts can be physically delivered instruments or financially exchanged vehicles.

A physically delivered contract requires that the buyer take delivery of an asset when the contract expires and moves to settlement.  For example, when NYMEX heating oil futures contract expires, the owner of a contract after expiration most take delivery of 42,000 gallons of heating oil in NY Harbor when the seller is prepared to deliver the contract.  The owner can always exit their position prior to expiration but if they hold the contract beyond the last trading date, they will need to be prepared to take delivery. With financial contracts, the buyer and the seller exchange payment based on the profit and loss calculation relative to the entry points and settlement price.

The profits and losses of a futures contract depend on the movements of the underlying market for that contract based on the difference between the entry price and the current price of the futures contract. For example, let’s say the futures contracts for oil increases $10 per barrel from the time the buyer of the contract purchases the WTI futures contract.

To calculate the profit (or loss) the buyer would multiple the price change by the number of contracts held and the number of barrels held in each contract.  In the case of WTI oil futures, there are 1,000 barrels per contract.  If an investor purchase 1 contract of WTI, and the price increased by $10 per barrel the investors would make $10,000 dollars ($10 * 1,000 barrels).

Benefits of Futures Contracts

The futures market has become an important devise used to determine commodity prices. Futures prices depend on the flow of global information which assists in the process of turning an opaque market into one that is relatively transparent.  There are multiple influences including weather, (hurricanes, heat and cold) as well as the fear of default, the political climate and economic performance that affect the price of a futures contract.

The futures markets also provide a market place for risk mitigation. Commercials who participate can use the futures market to reduce risk by hedging their exposure to commodities or interest rates, which increases the importance of a transparent liquid futures market.

Futures Exchanges

The exchanges with the most liquid futures contracts are the Chicago Mercantile Exchange and the Intercontinential Exchange. Both exchanges offer futures contracts on a broad array of products.  The CME is the home of the S&P futures contract along with the US Eurodollar and the Treasury note.  According to the CME, options are available across all major asset classes, including on interest rates, equity indexes, foreign exchange, energy, agricultural commodities, metals, weather and real estate. The ICE is the home of Brent Crude oil, along with all of the former NY Board of Trade soft commodity products.  Both exchanges use sophisticated risk management and margin analytics which provide traders the opportunity to leverage their futures trades.

Margin

Margin on futures contracts are set by the futures exchanges as well as the brokers who are member clearing firms.  Each futures contract will have a different margin requirement based on its historical movements. In many cases brokers will add an additional premium to the exchange minimum rate in order to lower their risk exposure. Margin is set by the risk a member firm is willing to assume by allowing a client to take a position in a futures contract.

Margin allows an investor to leverage their trades by putting up a fraction of the notional amount of the trade.  Equity investors can use margin but SEC regulation caps this amount at approximately 50%.  Futures margin will generally be much higher.  For example, current initial margin for gold contracts on the COMEX exchange are nearly 9K per 100 ounces.  With prices near 1,300 per ounce, an investor needs to post approximately 7% of the notional quantity of a gold futures contract to initiate a position ($1,300 * 100 / $9,000).  This allows an investor who purchases a gold futures contract to leverage at 14 to 1.

Most exchanges use a modified version of the SPAM risk array to calculate margin.  Initial margin is the amount an investor will have to place to initiate a trade.  This amount will be calculated based on the premise that a futures contract can move a specific amount on a daily basis.  The exchange is protecting its member clearing firms from an investor not having the required capital to pay for a loss.

Options on Futures

An option on a futures contract as mentioned earlier exercises directly into a futures contract.  This does not mean that a trader needs to accept delivery of a futures, as they can always sell (or buy back) the option prior to expiration.

Margin on futures options is similar to margin on stock options.  An option buyer will generally post the entire premium when purchasing options and the exchange will use the SPAN risk array to calculate margin on sold options.

Options on futures are usually American style options which allows the investor to exercise the options prior to an on the expiration date.  European style options as well as average priced options are also available. Investors can use options strategies in style that is similar to options on equities.  Futures options are available to trade straddles, strangles, butterflies, calls, puts, collars, ETC…

The futures market is global liquid markets that provide an opportunity for investors to speculate on the direction of global commodities, equities indexes, interest rates, and currencies.  Options on futures enhance the opportunities and allow investors to use a number of specific strategies to enhance their returns.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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