Options on futures, or “futures options,” offer market participants an unparalleled collection of opportunities. However, their name often confuses and discourages many active traders from entering the market. In this blog article, we’ll take a look at the basics of options on futures and three key advantages of making them part of your trading plan.
1. Simplicity
Futures options are options contracts that use futures contracts as underlying assets. Confused? Don’t be―these products function the same as traditional options contracts. Here is a quick look at the basics of futures on options:
- Strike price: Strike price is the building block of any options contract. It is a set price where the contract may be exercised.
- Calls and puts: There are two types of contracts: calls and puts. A call gives you the right to go long a market from a predetermined strike price. A put gives you the right to short a market from a predetermined strike price.
- Buying and selling: Options on futures contracts may be bought or sold. When a trader buys a contract, a premium is paid; when a trader sells a contract, a premium is received. If you buy a contract, your risk is limited to the premium paid; if you sell a contract, your risk is unlimited because you guarantee execution no matter what.
If you’ve ever traded traditional stock or commodity options, then learning the ins and outs of futures options should be routine. Like stocks or commodities, each product has an options chain that defines the contract’s premiums. A premium’s value depends upon whether a contract’s strike price is at the money (ATM), in the money (ITM), or out of the money (OTM). ATM and ITM contracts are assigned higher premiums than OTM contracts―simple as that.
2. Direct Market Exposure
At its core, a futures options contract’s functionality is exactly as its title dictates. It is an options contract that is based on a futures product. Accordingly, you can take long or short positions in a market by buying calls or puts.
As an example, let’s say that you are skittish about the market and think that gold has solid upside potential over the coming six months. It is early June, and CME December gold (GCZ) is trading at $1,750.00; given the emergence of new COVID-19 variants, you think that $2,000.00 by the late fall is a real possibility.
To go long gold using options on futures, all you have to do is buy a call contract at a desirable strike price. If you think that the current market price ($1,750.00) is an intermediate-term floor, then purchasing ITM, ATM, or OTM GCZ calls opens a new long position.
The beauty of this trade is that the only money risked is the cost of the premium. If you’re completely wrong and the price falls to $1,000, you only lose the premium. Conversely, if you were long one futures contract from $1,750.00 and price fell to $1,000.00, the result would be catastrophic (every $1.00 is worth $100, -$75,000).
3. Flexibility at Expiration
It is important to remember that all derivatives products have a finite shelf life. For futures and options, this comes in the form of an official expiration date. Upon expiry, a contract is taken off the board and becomes untradable.
For options on futures, the option contract typically expires one month before the underlying futures contract. This can be a good or bad thing for an open position because an option’s premium value is subject to time decay (delta). Although this relationship may seem confusing, it actually gives the trader several alternatives. Let’s say that you made your futures options play in June and bought one GCZ call with an $1,800 strike at a premium of $4,000. It is now mid-October, and GCZ has rallied to $1,875 (great call!). Here are your alternatives:
- Close out the position by selling one $1,800 GCZ call. It is now an ITM contract, with an expensive premium of $5,500. Your profit will be $1,500 ($5,500-$4,000).
- Exercise the option. By exercising the option, you assume a long position for one GCZ contract from $1,800. Your initial gain will be $3,500 ($75*100 = $7,500 – $4,000); however, this position’s value will fluctuate as GCZ pricing moves up and down.
Are You Ready to Trade Futures Options?
Sometimes the best way to learn about a subject is by talking to a true expert. For more information on how futures options can work for you, schedule a free one-on-one consultation with a Daniels Trading broker today.
