An option on a futures contract gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a strike price on or before the option’s expiration date. These operate similarly to stock options, but the underlying security here is a futures contract.
Most options on futures, such as index options, are cash settled. They often follow the European-style options model, meaning these assets cannot be exercised early.
Key Insights
- Options on futures resemble options on other securities but offer cash settlements and generally do not permit early exercise due to their European style.
- Mastering futures options involves attention to multiple variables and intricate contract specifications.
- Crucial details include contract specifics for both the option and the underlying futures contract.
Understand How Options on Futures Operate
An option on a futures contract works similarly to a stock option, granting the buyer the right to buy or sell the underlying asset. Conversely, it potentially obliges the seller to either buy or sell the asset if the buyer exercises their option. This structure makes futures options a second derivative: they are derivative securities contingent on another derivative security.
Thus, an option on an S&P 500 futures contract can be considered a secondary derivative of the S&P 500 index. Both options and futures contracts suffer time decay, necessitating traders’ vigilance regarding time decay dynamics.
- Call Options: The buyer can enter a long position at the option’s strike price for the underlying asset.
- Put Options: The buyer can enter a short position at the option’s strike price for the underlying asset.
Unlocking Profits: Example of Options on Futures
Consider an S&P 500 futures contract – prominently traded as the E-mini S&P 500. This contract allows controlling a cash value equivalent to 50 times the S&P 500 Index value. If the index stands at $3,000, the e-mini contract oversees $150,000 in cash. A 1% rise to $3,030 translates into a $1,500 increase, showing a potential 25% gain on a $6,300 trade margin.
However, instead of locking $6,300 in capital, buying an option can be more cost-efficient. Suppose with the index at $3,000, an option with a strike price of $3,010 is quoted at $17.00 with two weeks before expiration. Acquiring this option requires only $850 – a mere 85% of the margin amount and still aligning with $50 for every dollar of the index.
If the index rises similarly to $3,030 in one day, raising the option’s price from $17.00 to $32.00, the value increases by $750, reflecting an 88% increase on the initially risked amount, compared to 25% on the futures contract. Effectively, the strategy amplifies leverage efficiency beyond the futures alone.
Essential Considerations for Future Options Analysis
Key considerations include assessing the fair value of contracts relative to the underlying asset’s spot price. This difference is the futures contract’s premium.
Options enable more substantial asset control with minor financial inputs via favorable margin rules, known as SPAN margining, further enhancing leverage and profit potential. Yet, it also heightens the potential loss risk to the total price of the contracts purchased.
A notable distinction between futures and stock options lies in their valuation changes with stock prices versus contract specifics such as commodity, index, index futures, or bonds. Each futures contract’s value significantly influences the trading strategy and associated leverage.
Employ carefully tailored strategies to harness the potential of options on futures, appreciating the precise nuances of each market dynamic for enhanced trading outcomes.
Related Terms: stock options, derivatives, trading margin, SPX index.
References
- Corporate Finance Institute. “Options: Calls and Puts”.
