Options on Futures
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Options on futures were introduced in the 1980s. An option contract allows you the right, but not the obligation, to buy or sell an underlying futures contract at a particular price.
What does an option on a futures contract specify?
- The commodity and the contract month of the futures contract
- The right to buy or sell the futures contract.
- The price at which the futures contract will be bought or sold.
Say that again!
An option is the right, but not the obligation, to buy or sell an underlying futures contract at a specified price. For example, you could purchase an option to buy a December Swiss franc futures contract at 88¢ per Swiss franc (an option to buy is a “call” option).
What do you do once you buy the Swiss franc option? You watch price movement. Suppose the December Swiss franc futures price rises above 88¢. You could exercise the option and assume a long December Swiss franc futures contract. You would have bought futures contract at 88 that you could sell immediately at the higher price (buy low, sell high). But you don’t have to. With prices above 88¢, your option would have increased in value, so you could choose to offset it by selling back the same option at a profit. If the futures price falls below 88¢, the option would have decreased in value. Then you can simply forget about it and let it expire, losing the money you paid for it.
Puts and calls
There are special names for options, depending on whether the option is for the right to buy or sell a futures contract. A “put” option is the right, but not the obligation, to sell a futures contract at a particular price. A “call” option is the right, but not the obligation, to buy a futures contract at a particular price. These terms originated from the concept of putting a commodity on the market (selling) and calling a commodity from the market (buying).
Figure it out.
The futures price is 88 cents, a Swiss franc 90 call option would be:
a) In the money
b) At the money
c) out of the money
In options trading, the buyer has a right, the seller has an obligation. An option buyer purchases the right, but not the obligation, to buy or sell the underlying futures contract at a specified price. For every option bought, someone has to sell that option.
The Option Seller
A person can be an option seller (also called an option writer) who sells put or call options. An option seller assumes obligation when an option buyer exercises their right.
Options on futures contracts were first traded in October of 1982 when the Chicago Board of Trade (CBOT) began trading options on T-bond futures. Soon after, Chicago Mercantile Exchange (CME) opened its Index and Options Market (IOM) division which offered options on stock index futures, Eurodollar futures and T-bill futures. In that first year of 1982, only 177,350 options contracts were traded. Look at the growth that followed.
Options Contracts Traded (Numbers Rounded)
1985 - - - 20 million
1990 - - - 64 million
1999 - - - 115 million
What options are traded?
Today at the U.S. exchanges, options are available on a great variety of futures contracts. These include the following commodity groups: Agricultural commodities, foreign currencies, interest rate products, equity indices, energy products and metals. More options are traded on interest rate futures than any other category.
As with futures trading, most of the options on futures contracts traded in the U.S. occur on the Chicago futures exchanges. The CBOT, CME and the MidAmerica Commodity Exchange trade over 85% of all options traded in the country. Almost 15% are traded at New York exchanges.
Source: Chicago Mercantile Exchange
Options Risk Disclosure: An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price. Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different. For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option. Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options). Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised. The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero. Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received). The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.