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Options on futures are derivative instruments similar to the options you might buy on a single stock, but instead of the underlying asset being shares of a specific company, the underlying asset is a futures contract.
An option on a futures contract gives the holder the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) a specific futures contract at a predetermined price (the strike price) on or before a certain date (the expiration date).
Options on futures work much like options on stocks, but instead of the right to buy or sell shares of a company's stock at a certain price on or before a certain date, an option on a futures contract gives the buyer the right (but not the obligation) to enter into a specified futures contract.
One key difference between options on futures and options on stock is that futures contracts have different expiration dates as well, so one futures option expiration could point to a futures contract that is different from another futures option expiration.
Here’s how options on futures work for buyers of futures calls and puts:
Call Option on Futures: If you buy a call option on a futures contract, you have the right (but not the obligation) to assume a long position in the underlying futures contract at the strike price on or before the expiration date. If the futures price rises above the strike price, you could theoretically profit by exercising the option and then selling the futures contract at the higher market price.
Put Option on Futures: If you buy a put option on a futures contract, you have the right (but not the obligation) to assume a short position in the underlying futures contract at the strike price on or before the expiration date. If the futures price falls below the strike price, you could profit by exercising the option and then buying the futures contract at the lower market price to cover your short position.
Sellers (also called writers) of options on futures have different obligations compared to the buyers, as detailed below:
Call Option Sellers: When you sell (or "write") a call option on a futures contract, you receive a premium upfront. In return, you are obliged to sell the underlying futures contract to the option buyer at the specified strike price, if the option is exercised by the buyer before it expires.
If the price of the futures contract remains below the strike price of the call option until expiration, the option would be out-of-the-money and would likely not be exercised. In this case, as the seller, you would keep the premium as profit.
If the price of the futures contract rises above the strike price, the option would be in-the-money and the buyer might exercise the option. As the seller, you would be obliged to sell the futures contract at the lower strike price, potentially resulting in a loss. Your maximum loss could be substantial because there is no upper limit to how much the price of the futures contract might rise.
Put Option Sellers: When you sell (or "write") a put option on a futures contract, you receive a premium upfront. In return, you are obliged to buy the underlying futures contract from the option buyer at the specified strike price, if the option is exercised by the buyer before it expires.
If the price of the futures contract remains above the strike price of the put option until expiration, the option would be out-of-the-money and would likely not be exercised. In this case, as the seller, you would keep the premium as profit.
If the price of the futures contract falls below the strike price, the option would be in-the-money and the buyer might exercise the option. As the seller, you would be obliged to buy the futures contract at the higher strike price, potentially resulting in a loss. Your maximum loss is the strike price (multiplied by the size of the contract), less the premium received, because the price of the futures contract cannot fall below zero.
Selling options on futures can be extremely risky, especially if the position is unhedged (i.e. a naked short option position). Sellers face potentially substantial losses if the market moves against their position. Before selling options, it's important to understand these risks and to have a risk management plan in place.
Buying options can also be risky, but in this case, the maximum loss is the amount of premium outlaid to enter the position.
Trading options on futures, like all investment and trading approaches, has its pros and cons. Here are some of the general pros and cons of trading options on futures:
Flexibility: Options on futures can be used in a variety of strategies, from hedging risk to speculating on price movements to generating income. They can be a flexible tool for sophisticated investors
Leverage: Like futures, options on futures offer the possibility of high returns due to the leverage they provide. A relatively small amount of capital can control a much larger amount of the underlying asset
Limited Risk for Buyers: For the buyer of an option, the risk is limited to the premium paid for the option. Unlike futures, where potential losses can be substantial, an options buyer can't lose more than the premium
Complexity: Options on futures are complex financial instruments, with prices influenced by many variables (i.e. price of the underlying asset, time until expiration, volatility). Understanding these factors and how they interact can be challenging, particularly for inexperienced investors and traders
Potential for Significant Losses: For sellers of futures on options, potential losses can be substantial. If the market moves significantly against the seller's position, they could face large losses
Costs: Trading options on futures can involve several types of costs, including commissions, bid-ask spreads, and, for options buyers, the premium
Risk of Illiquidity: Some options on futures may be illiquid, meaning they are not traded frequently. Illiquidity can make it difficult to enter or exit positions at favorable prices
Detailed below are two different examples of options on futures, one involving a call option and one involving a put option.
Put Options on Futures Example
Imagine it's July and you believe the price of gold is going to fall by December due to expected market conditions.
You decide to buy a put option on gold futures with a strike price of $1,500 per ounce that expires in December.
The premium for this option is $50 per ounce. Each futures contract represents 100 ounces, so you pay $5,000 for the option ($50 per ounce * 100 ounces).
Hypothetical Scenario 1: By December, the price of gold drops to $1,400 per ounce. The option is now "in-the-money," and you decide to exercise the option. You sell a gold futures contract (100 ounces) at the strike price of $1,500 per ounce, earning you $150,000. You can then buy the futures contract immediately in the open market at the current price of $1,400 per ounce for $140,000. Your profit, excluding transaction costs, is $5,000 ($150,000 - $140,000 - $5,000 for the premium).
Hypothetical Scenario 2: By December, the price of gold rises to $1,600 per ounce. The option is now "out-of-the-money," and it doesn't make sense to exercise the option. The option expires worthless, and your loss is the premium you paid, which is $5,000.
Imagine it's July and you believe the price of wheat is going to rise by October due to some anticipated market conditions.
You decide to buy a call option on wheat futures with a strike price of $5 per bushel that expires in October.
The premium for this option is $0.20 per bushel. Each futures contract represents 5,000 bushels, so you pay $1,000 for the option ($0.20 per bushel * 5,000 bushels).
Hypothetical Scenario 1: By October, the price of wheat rises to $6 per bushel. The option is now "in-the-money," and you decide to exercise the option. You buy 5,000 bushels of wheat futures at the strike price of $5 per bushel, costing you $25,000. You can then sell the futures contract immediately in the open market at the current price of $6 per bushel for $30,000. Your profit, excluding transaction costs, is $4,000 ($30,000 - $25,000 - $1,000 for the premium).
Hypothetical Scenario 2: By October, the price of wheat drops to $4 per bushel. The option is now "out-of-the-money," and it doesn't make sense to exercise the option. The option expires worthless, and your loss is the premium you paid, which is $1,000.
Imagine it's July and you believe the price of gold is going to fall by December due to expected market conditions. You decide to buy a put option on gold futures with a strike price of $1,500 per ounce that expires in December.
The premium for this option is $50 per ounce. Each futures contract represents 100 ounces, so you pay $5,000 for the option ($50 per ounce * 100 ounces).
Hypothetical Scenario 1: By December, the price of gold drops to $1,400 per ounce. The option is now "in-the-money," and you decide to exercise the option. You sell a gold futures contract (100 ounces) at the strike price of $1,500 per ounce, earning you $150,000. You can then buy the futures contract immediately in the open market at the current price of $1,400 per ounce for $140,000. Your profit, excluding transaction costs, is $5,000 ($150,000 - $140,000 - $5,000 for the premium).
Hypothetical Scenario 2: By December, the price of gold rises to $1,600 per ounce. The option is now "out-of-the-money," and it doesn't make sense to exercise the option. The option expires worthless, and your loss is the premium you paid, which is $5,000.
Futures and options are both financial derivatives, but they work in different ways and have different characteristics, as outlined below:
Obligation vs. Right: A futures contract is an obligation. If you buy a futures contract, you are agreeing to buy the underlying asset at a specific price on a specific future date. If you sell a futures contract, you are agreeing to sell the underlying asset at a specific price on a specific future date. In contrast, an option gives you the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a specific price before the option expires.
Risk vs. Reward: Because futures contracts are obligations, they can lead to significant profits or losses. The potential for loss is theoretically unlimited for the seller of a futures contract and is substantial for the buyer. Options, on the other hand, have limited risk for the buyer (the most you can lose is the premium you paid), but unlimited potential profit. For the seller of an option, the risk can be substantial, but the reward is limited to the premium received.
Premiums: Options require the payment of a premium to the seller by the buyer. This premium is determined by several factors, including the time until expiration, the price of the underlying asset, the strike price, and volatility. Futures contracts do not require an upfront premium. Instead, they require a margin deposit, which is a fraction of the contract's value.
Daily Settlement: Futures contracts are "marked to market" daily, meaning that gains and losses from each day's trading are added to or deducted from the trader's account each day. Options are not marked to market in this way; the buyer's potential losses are limited to the premium paid, and the seller's potential losses (which are theoretically unlimited) can accumulate until the option is exercised or expires.
Underlying Asset: Both futures and options contracts can be made for a wide variety of underlying assets, including stocks, bonds, commodities, currencies, interest rates, and indexes.
Options on futures can be used in various ways depending on the investor's goals, market expectations, and risk tolerance. Here are several common uses:
Hedging: Options on futures can be used to hedge risk, whether it be position/portfolio risk, or risk in a business operation. For example, a farmer who's worried about the price of wheat falling before harvest could buy a put option on wheat futures. If the price of wheat does indeed fall, the increase in the value of the put option could offset the decrease in the value of the farmer's crop.
Directional Speculation: Options on futures can also be used to speculate on the direction of the price of the underlying asset. If an investor or trader believes the price of gold will rise, he/she might buy a call option on gold futures. If the price of gold does rise, the value of the call option would likely increase, and the call owner could potentially sell the option for a profit. On the other hand, if an investor or trader believes the price of gold will fall, he/she might buy a put option on gold futures.
Neutral Speculation: When market expectations for future price volatility are high, options premiums tend to be higher. In such situations, a trader who believes the price of the underlying asset will remain stable might sell options to collect the premium as income. However, this strategy is risky because if the price of the underlying asset does move significantly, the seller could face substantial losses.
Spreads: Sophisticated investors and traders may decide to use options on futures to create spread positions. Spreads involve buying and selling different options on the same underlying asset. Spreads can be used to profit from price differences, to limit risk, or to take advantage of expected changes in price volatility.
It’s important to keep in mind that trading options on futures can be complex and may involve substantial risk. Investors and traders therefore need to understand how these instruments work before entering this market, to ensure that the potential risks are acceptable.
Listed below are some of the general guidelines investors and traders can follow when getting started trading options on futures:
Learn what futures options are and how they work: Before entering the market, learn as much as you can about options and futures. This includes understanding the terminology, how these instruments work, and the risks involved. There are many resources available online, including tutorials, articles, and webinars
Open a tastytrade account: On tastytrade you can trade options on futures with low commissions, starting from only $0.50, across a wide range of asset classes and you can utilize, mini, micro and Smalls futures options contracts which enable you to trade with less capital. Open a tastytrade account today
Risk assessment: Assess your risk tolerance. Futures and options can involve substantial risk, and it's crucial to understand this before you start trading. Never trade with money you cannot afford to lose
Develop a trading strategy: This should involve deciding what underlying assets you will trade, whether you will buy or sell options, what your entry and exit points will be, and how you will manage your risk
Learn the trading platform: Get familiar with your broker's trading platform. You'll need to know how to place trades, monitor your positions, and use any tools or features that are part of the platform
Monitor your trade: After you deploy your first trade(s), regularly monitor your positions and overall market conditions. You may need to adjust your positions in response to changing market conditions, or to manage risk in the position or portfolio. You can create futures alerts on the tastytrade platform that notify you when a product reaches a certain price level, for example
Review: Regularly review your trading performance and approach. Look for any patterns or lessons you can learn from your successful and unsuccessful trades, and adjust your strategy accordingly
Remember that futures and options trading is complex and can involve substantial risk. It may not be suitable for all market participants. As always, you should only risk capital that you can afford to lose. It may also be prudent to seek advice from a financial advisor or a professional with experience in futures trading before entering the market.
Check out all of the futures products and sectors you can trade at tastytrade.
Options on futures are derivative instruments similar to the options you might buy on a single stock, but instead of the underlying asset being shares of a specific company, the underlying asset is a futures contract.
An option on a futures contract gives the holder the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) a specific futures contract at a predetermined price (the strike price) on or before a certain date (the expiration date).
In order to buy an option on a future, an investor or trader would follow these basic steps:
Choosing the Right Contract: Just as with regular options, options on futures have various strike prices and expiration dates. A trader chooses a specific futures option contract based on their market expectations, risk tolerance, and investment strategy.
Buy the Option: To initiate the transaction, the buyer pays a premium to the seller (also called the writer) of the option. The premium is the price of the option and is determined by various factors, including the strike price, the current price of the underlying futures contract, the time to expiration, and market volatility.
Exercise the Option: If an option buyer chooses to exercise their right, then the process is as follows for calls and puts:
For a call option (which gives the holder the right to buy), if the price of the underlying futures contract is above the strike price, the buyer can exercise the option and take a long position in the futures contract at the strike price. They could then potentially sell the futures contract at the current (higher) market price for a profit.
For a put option (which gives the holder the right to sell), if the price of the underlying futures contract is below the strike price, the buyer can exercise the option and take a short position in the futures contract at the strike price. They could then potentially buy the futures contract at the current (lower) market price to cover the short position, earning a profit.
Sell the Option (i.e. close the position): The buyer of the option can also choose to sell the option contract before expiration to close out the position. Whether that sale will result in a profit or loss will depend on changes to the underlying futures contract, which likewise impact the value of the option.
The risk associated with trading options on futures contracts can be significant and depends largely on the role you take (buyer or seller) and the specifics of your trading strategy. Here's a general breakdown:
Buyers of Options: For buyers of options (either calls or puts), the risk is generally limited to the amount of the premium paid for the option. If the market doesn't move in the direction you anticipated, the option may expire worthless, resulting in a total loss of the premium paid. But, unlike futures contracts, your losses as an options buyer are capped at this amount.
Sellers of Options: For sellers (or "writers") of options, the risk can be substantial. When you sell an option, you're taking on an obligation to buy or sell the underlying futures contract at the strike price if the option is exercised. If the market moves significantly against your position, your losses can be significant.
For call options, your risk is potentially unlimited because there's no upper limit to how high the price of the futures contract could rise.
For put options, your risk is substantial but limited because the price of the futures contract cannot fall below zero.
As with all forms of investing and trading, it's crucial to have a clear understanding of these risks before getting involved. Be sure to educate yourself thoroughly, develop a clear trading plan and risk management approach, and consider seeking advice from a professional.
An investor or traders may choose to trade options on futures as opposed to options on stocks for a variety of reasons, including some of those outlined below:
Broad Market Exposure: Options on futures often provide exposure to broader market indices or commodities, allowing traders to speculate on or hedge against overall market movements or commodity prices rather than individual companies.
Leverage: Futures contracts generally involve a larger amount of the underlying asset compared to individual stock options. This can provide greater leverage, allowing for the potential of higher returns (although this also means increased risk).
24-hour Trading: Futures markets typically operate nearly 24 hours a day, providing the opportunity to respond to global news and events that happen outside of standard stock market hours.
Diversification: Trading options on futures can add another layer of diversification to an investment portfolio. Diversification can help manage risk by spreading investments across different types of assets.
Potential for Enhanced Liquidity: For some underlying assets, the futures market may be more liquid than the equivalent options on individual stocks. That may translate to narrower bid-ask spreads and the ability to enter and exit positions more easily.
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