by Amanda Harvey
Futures options trading involves buying an option contract in which the underlying asset is a futures contract. Like stock options, futures options are priced at a percentage of the cost of the underlying asset. This means that trading futures options enables a trader to participate in the arena of futures trading for a smaller outlay of capital.
How Does Futures Options Trading Work?
When a trader buys a futures option they pay a premium and become entitled to, but not required to, buy a specific futures position at a prearranged price at any time during the life of the option contract.
For the duration of the contact, the option holder may also sell the option contract at an increased price to realize a profit, or they may sell at a loss to avoid losing their entire premium if they believe that the option is in danger of expiring worthless. If a futures option expires without reaching its strike price, it has no value.
Like many types of options, futures options may be used for speculative trading which aims to take advantage of movement in price of the underlying asset. They may also be used as a means of hedging futures investments.
How Do Traders Profit From Futures Options Trading?
Upon expiration date, if the option contract has not been sold and is in-the-money, it will be settled. This settlement is often in the form of the underlying future; however, there are also futures option contracts that settle in cash.
Many traders involved in futures options trading do not intend to exercise their options by buying futures. They simply plan to take advantage of the movement of the futures value by selling their options for a higher price than the premium they paid.
How Are Options on Futures Priced?
As with stock options, futures options’ premiums are based primarily on the value of the underlying asset. In this case, the asset is the futures contract, and not the commodity on which the future is based. While futures prices tend to mirror commodity prices fairly closely, in order to make accurate trading decisions, the main focus must be on the futures price.
In the calculation of option premiums, there are several factors taken into account, including the gap between the current futures price and the strike price. According to this gap, the option may be deemed out-of-the-money, at-the-money, or in-the-money. Another factor is the length of time before expiration of the option – generally more time translates to a higher premium, as the contract has a better possibility of attaining a profit. A very important component in the pricing of all options is the volatility of the underlying asset.
Expiry Dates for Futures Options Trading
Most options expire the month before the expiration of the underlying futures contract; usually near the end of the month on a Friday. The exception to this is options on futures which are settled in cash. These options expire in the same month as the futures contract.
Trading future options can be a viable and profitable way of capitalizing on the movements in the futures markets with less risk and outlay than actually trading futures. With an understanding of both futures trading and options trading, this area may present some attractive trading possibilities.