Future and Options are a type of derivative instruments. These help investors to hedge their risk, as well as speculate on the future price movement. Investors can also combine the two instruments to achieve their financial objectives. And we call this combination as ‘Options on Futures.’
In simple words, options on futures give the holder an option to buy or sell a futures contract at a set future date and agreed price. We can say that it gives buyers the right to buy or sell a futures contract with no obligation. Another name for such an instrument is futures options.
- Options on Futures – How it Works?
- Why Use Options on Futures?
- Points to Consider
- How to Hedge Using Options on Futures?
There are different types of futures option. These are – Options on index future, Options on currency future; Future options in the share market; and Options on interest rate futures.
Traders or investors in such instruments basically speculate on the futures contracts price and not the asset, which is part of that futures contract. One primary reason for this is that prices of the futures contract and their underlying security do not always move together. In fact, the prices of the two can go in reverse directions as well.
Thus, it is very crucial that traders or investors have a good knowledge of options and futures trading before using futures options.
Options on Futures – How it Works?
This type of option works very similar to the equity option. The only difference is that the underlying security here is a futures contract and not the security/stock. So, when the holder exercises the option, what they get is a futures position (and not any asset).
Call Option on Future
In the case of call options on the future, the holder gets the right (not obligation) to acquire the futures contract at a set price in the future. Similarly, in the case of a put, the holder gets the right (not obligation) to short the futures contract at the set price.
In a call futures option, the buyer gets a long position in the underlying futures. Also, the holder needs to pay the initial margin amount and an amount equivalent to the difference between the strike and the current futures price of the futures contract.
The holder needs to pay these amounts because they would only use the option if it is In-the-Money. Or when the strike price of the futures option is less in comparison to the current futures price of the futures contract.
Talking about the seller of the call futures option, they get a short position in the futures contract. The seller also needs to pay an initial margin amount and the mark to market margin in cash. That is the difference of the strike and the current futures price.
Put Option Future
When the holder believes that the market will move downward, he will buy the put option futures. Thus, the investor gets a short position in the underlying futures. The holder here also needs to pay the initial margin amount and the difference of the strike and the current futures price of the futures contract. Generally, the option only gets exercised when the option is In-the-Money. Or, the holder will use the option when the strike rate of the futures option is more than the spot futures price of the futures contract.
The put futures option seller takes an opposite stand. Or the seller gets a long position in the futures contract. Like the buyer, the seller also needs to pay the initial margin money and the mark to market margin in cash—the difference between the strike price and the current futures price.
Why Use Options on Futures?
Limited Availability of Options
The biggest reason to use the futures option is when there are not any options available for a particular asset. And the only alternative available in the futures and futures option. In such a case, the futures option is the closest alternative available to trade options for that asset.
Limit Exposure to Risk
However, nowadays, options are there for all the assets. So, the next best use case of futures options is that it helps to hedge against futures positions. As you know, futures trading carries a large risk, so by using the futures option, a trader can significantly limit their exposure to the risk.
Availability of Futures Options
Another case of the use of futures option is their availability. Some futures options that trade on the CME (Chicago Mercantile Exchange) are available for full-day (24 hours). Such an advantage is not there with the plain vanilla stock options.
Points to Consider
Traders, who plan to use futures options, must take special note and understanding on the following points:
Generally, the expiration month of futures options is before the delivery month of the futures agreement. Moreover, the futures options usually expire on Friday.
If the holder exercises the futures option, then the strike price is the rate at which the futures position will open in the trading accounts of both parties.
Exercise & Assignment
The buyer and seller of the futures option will take up a long or a short position on the basis of if they hold a call or put option. For instance, the buyer assumes a long futures position in the call option, and the seller assumes a short futures position.
Futures Option Pricing
A trader must never forget that the underlying security is a futures contract in futures options. The price of a futures contract may or may not move like any other asset. So, even a small unfavorable movement in highly leverage products could vastly magnify losses.
How to Hedge Using Options on Futures?
Depending upon a traders’ futures position, they can hedge their risk using futures options in the following ways:
If a trader is in the long futures and wants some protection from the downside risk, then they could go for Put Options on Futures. The underlying futures contract will be the same on which the trader already has a long position. Also, Put Options on Futures will have the same strike price as the futures contract.
We call such a strategy ‘Protective Put.’ Such a strategy will help a trader/investor to hedge/cover his position against the sudden drop in the prices way below the strike price of the put futures options.
In case the trader expects only a marginal drop in the futures position price, then they could hedge in another way. The trader can short At-the-Money or marginally Out-of-the-Money call options on the futures. We call such a strategy ‘Covered Call.’
The seller of the call futures options gets a premium. This premium helps offset a drop in futures positions price until the futures price is less than the strike price.
Suppose a trader is in short futures and wants to hedge the position from any upside risk. Then they need to acquire the call futures option. We call such a strategy ‘Protective Call.’ This strategy helps traders/investors to hedge against the rise in the price over the strike price of the call futures option.
In case the trader expects only a marginal rise in the price of the futures position, then they could hedge by shorting At-the-Money, or marginally Out-of-the-Money put options. We call such a strategy a ‘Covered Put.’
The seller of the put futures options gets the premium that compensates for the rise in the futures position price. The premium would offset until the futures price is more than the strike price.