Options on futures

LINK_POOL:

• Futures Contracts
• Options Trading
• Call Option
• Put Option
• Strike Price
• Expiration Date
• Underlying Asset
• Hedging
• Speculation
• Premium
• Derivatives
• Margin
• Volatility
• Commodity Markets
• Risk Management

What Is Options on Futures?

Options on futures are a type of derivative contract that gives the buyer the right, but not the obligation, to buy or sell a specific futures contract at a predetermined strike price on or before a specified expiration date. These financial instruments fall under the broader category of options trading and are primarily used in the commodity markets, as well as for interest rates, foreign exchange, and equity indexes. Unlike direct futures contracts, which carry an obligation to buy or sell the underlying asset, options on futures limit the buyer's risk to the initial premium paid for the option.

History and Origin

The concept of options dates back centuries, with early forms of options contracts reportedly used in ancient Greece by merchants to manage risk in the olive oil and wine trade¹⁷. The modern history of options trading, particularly options on futures, began to take shape in the 17th century when Dutch merchants used them to hedge against price fluctuations for goods not yet ready for sale¹⁵, ¹⁶.

However, the formalization and widespread adoption of options trading, including options on futures, gained significant momentum in the 20th century. A pivotal moment was the establishment of the Chicago Board Options Exchange (CBOE) in 1973, which standardized option contracts and provided a centralized exchange for trading¹³, ¹⁴. Prior to this, options were largely traded over-the-counter with minimal regulation and standardization¹¹, ¹². The Commodity Futures Trading Commission (CFTC), created in 1974, now regulates the U.S. derivatives markets, including futures, swaps, and certain types of options, further solidifying their place in the financial landscape.

Key Takeaways

• Options on futures provide the holder the right, but not the obligation, to buy or sell a futures contract.
• The maximum risk for the buyer of an options on futures contract is limited to the premium paid.
• These instruments are versatile tools for hedging against adverse price movements and for speculation.
• They are actively traded on exchanges like CME Group, offering liquidity across various asset classes¹⁰.
• Regulations from bodies like the CFTC ensure market integrity and transparency in options on futures trading.

Formula and Calculation

The pricing of options on futures is complex and considers several factors, including the price of the underlying futures contract, the strike price, the time remaining until expiration, the risk-free interest rate, and the expected volatility of the underlying futures price. While a precise formula like the Black-Scholes model for equity options exists, its application to options on futures involves adapting for the nuances of futures contracts.

One of the core components influencing an option's premium is its intrinsic value and time value.
The intrinsic value for a call option on a futures contract is:
$\text{Intrinsic Value}_{\text{Call}} = \text{Max}(0, \text{Futures Price} - \text{Strike Price})$
The intrinsic value for a put option on a futures contract is:
$\text{Intrinsic Value}_{\text{Put}} = \text{Max}(0, \text{Strike Price} - \text{Futures Price})$
The total premium paid for an option on a futures contract is the sum of its intrinsic value and time value:
$\text{Premium} = \text{Intrinsic Value} + \text{Time Value}$
The time value of an option erodes as the expiration date approaches, eventually becoming zero at expiration.

Interpreting the Options on Futures

Interpreting options on futures involves understanding their dual nature as tools for both risk management and speculation. For buyers, the limited risk (the premium paid) makes them attractive for expressing a directional view on the underlying asset's price without the unlimited downside exposure of a direct futures position. A buyer of a call option on futures anticipates the futures price to rise above the strike price, while a buyer of a put option on futures expects the futures price to fall below the strike price.

Conversely, sellers of options on futures take on potentially unlimited risk in exchange for the premium. They are typically looking to profit from the option expiring worthless or from a decrease in volatility. Understanding the relationship between the futures price, strike price, and time to expiration is crucial for effective interpretation and strategic decision-making in options on futures.

Hypothetical Example

Consider an investor, Sarah, who believes that crude oil futures, currently trading at $80 per barrel, will rise in the coming months. Instead of buying a crude oil futures contract directly, which would require significant capital and expose her to substantial downside risk, she decides to purchase a call option on a crude oil futures contract.

Sarah buys one call option contract with a strike price of $85 and an expiration date three months from now, paying a premium of $2 per barrel (or $2,000 for a standard 1,000-barrel contract).

• Scenario 1: Crude oil futures rise. If, by the expiration date, crude oil futures are trading at $95 per barrel, Sarah's call option is "in the money." She can exercise her right to buy the futures contract at $85 and immediately sell it in the market at $95, realizing a profit of $10 per barrel ($95 - $85). After deducting the $2 premium, her net profit is $8 per barrel, or $8,000 for the contract.
• Scenario 2: Crude oil futures fall or stay flat. If, by the expiration date, crude oil futures are trading at $80 or below, Sarah's call option expires "out of the money" and worthless. She will not exercise her right. Her maximum loss is limited to the $2 premium she paid, or $2,000 for the contract.

This example illustrates how options on futures can provide leveraged exposure to price movements with defined maximum risk for the buyer.

Practical Applications

Options on futures serve various practical applications in financial markets and beyond:

• Hedging Price Risk: Businesses and producers heavily rely on options on futures for hedging. For instance, an airline might buy call options on crude oil futures to cap their fuel costs, protecting against rising oil prices. Similarly, a farmer might buy put options on a grain futures contract to set a minimum selling price for their crop, guarding against price declines. This is a core function in risk management strategies. The CME Group offers various options on futures products across asset classes for this purpose⁸, ⁹.
• Speculation and Leveraged Exposure: Traders use options on futures for speculation to profit from anticipated price movements in the underlying futures market. Since the premium is a fraction of the futures contract's total value, options offer leveraged exposure. For a relatively small outlay, a trader can control a large notional value of the underlying asset.
• Generating Income: Sellers of options on futures, also known as option writers, can collect premiums from buyers, generating income. This strategy is typically employed when the seller believes the underlying futures price will remain stable or move in a favorable direction (e.g., selling a call if they expect the price to fall or stay below the strike).
• Portfolio Diversification: Options on futures can be used to diversify a portfolio by gaining exposure to various asset classes like commodities, currencies, and interest rates without directly holding the physical assets or committing to full futures contracts⁷.
• Risk Management for Futures Positions: Options can act as "insurance" for existing futures contracts. For example, a long futures position can be protected with a long put option, limiting potential downside if the futures price drops⁶. Research papers explore how options on futures can be used to manage liquidity risk inherent in futures positions⁵.

Limitations and Criticisms

While options on futures offer significant advantages, they also come with limitations and criticisms that market participants should consider:

• Complexity: Options on futures, particularly advanced strategies involving combinations of calls and puts, can be complex to understand and implement. This complexity can lead to misjudgment and potential losses for inexperienced traders.
• Time Decay: The premium of an option includes time value, which erodes as the expiration date approaches. This "time decay" works against the option buyer, meaning the underlying futures price must move sufficiently in the desired direction to overcome this erosion.
• Liquidity Risk: Although major options on futures markets are generally liquid, some less actively traded contracts or those with distant expiration dates may suffer from lower liquidity. This can make it challenging to enter or exit positions at favorable prices⁴.
• Unlimited Risk for Sellers (Naked Options): While buyers' risk is limited to the premium paid, sellers of "naked" options (those not backed by an underlying position) face potentially unlimited losses. For instance, a naked call option seller could incur substantial losses if the underlying asset's price rises sharply.
• Transaction Costs: Trading options on futures involves various fees and commissions, which can eat into potential profits, especially for frequent traders or small positions.
• Regulatory Scrutiny: The complexity and potential for leverage in derivatives, including options on futures, have led to increased regulatory scrutiny. While regulations aim to protect market integrity, they can also impose restrictions or alter market dynamics. The Commodity Futures Trading Commission (CFTC) provides oversight and regulatory frameworks for these markets², ³. Research also analyzes selected risks within futures and options markets¹.

Options on Futures vs. Futures Contracts

Options on futures and futures contracts are both derivatives that derive their value from an underlying asset and are used for hedging and speculation. However, a key distinction lies in the obligation they impose:

The primary area of confusion arises because both instruments provide exposure to the future price of an asset. However, the "optionality" in options on futures provides a distinct risk-reward profile, giving the buyer the choice to exercise, unlike the firm commitment of a futures contract.

FAQs

What is the main advantage of options on futures over direct futures contracts?
The main advantage is that options on futures provide limited risk for the buyer, capping potential losses to the premium paid. In contrast, direct futures contracts involve an obligation to buy or sell the underlying asset, leading to potentially unlimited losses if the market moves unfavorably.

Can options on futures be used for speculation?
Yes, options on futures are widely used for speculation. Traders can use call options if they expect the futures price to rise, or put options if they anticipate a decline, benefiting from price movements with a relatively smaller capital outlay due to leverage.

Are options on futures regulated?
Yes, in the United States, options on futures are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC oversees the derivatives markets to ensure integrity, prevent fraud, and protect market participants.

What factors influence the price of an options on futures contract?
The price, or premium, of an options on futures contract is influenced by several factors: the current price of the underlying futures contract, the strike price, the time remaining until the expiration date, market volatility, and prevailing interest rates.