What is a Future Option
A futures option is a type of security that grants the trader the right to buy or sell a futures contract at a specific price by a specific date. There are two types of futures options: call options and put options. Call options give the owner the right to buy a futures contract, Put options give the owner the right to sell a futures contract. Traders will buy call options when they think the market will rise, and they will buy put options when they think the market will fall.
Futures options are offered to trade on most futures contracts and are traded on various exchanges throughout the United States and internationally. The largest of these exchanges is the Chicago Mercantile Exchange. Futures options are generally traded in a separate futures account with a futures broker dealer.
Each futures options contract has unique contract specifications which make them more complex to trade than stock options or individual futures contracts. Specifically, futures options often have a different expiration date prior to the expiration date of the underlying future. Futures options usually expire near the end of the month that precedes the delivery month of the underlying futures contract (i.e. March option expires in February).
Each futures option contract also has the same contract value as the underlying future, which represents the amount of the commodity to be traded. For example, a crude oil futures contract represents 1000 barrels of crude oil which has a value of approximately $60,000 (1000 X $60 per barrel).
In order to trade any futures contract, traders are required to put up a good faith deposit called margin, which sets aside money in your account in the event of losses. For example, to trade one Crude Oil contract would require $5,000 of margin in order to control 1000 barrels of crude oil. Day traders who do not hold their position overnight get a reduced margin rate of 12.5 to 25 percent of the overnight rate.
Futures options are traded in contracts, and each futures option contract represents 1 contract of the underlying commodity. There can be multiple weekly and monthly futures option contract series that all relate or deliver into the same unique underlying futures contract.
The price or premium of a futures option contract is determined by a number of pricing factors that include:
- The underlying futures price
- The contract strike price at which you can buy or sell the future at expiration
- The expiration date of the contract
- Volatility as a function of risk to the trader selling the call or put
The price quoted for a futures option is the per-contract price of the option. So, if an option is quoted at $2 and the point value of the underlying futures contract is 1000, the cost to buy that futures option would be $2,000 ($2 X 1000 shares).
Learning which futures option to buy or sell and when to buy or sell, when to hold your position and when to close your position requires knowledge and experience you can gain through education and coaching.
Why Trade Futures Options
Futures options combines the benefits of both trading futures and trading options and offers a number of advantages over other financial instruments.
Limited Risk – Buying a call or put futures option offers the trader unlimited potential profit and limits maximum risk to the price premium paid for the option. Conversely, the options seller has unlimited risk and can only profit by the amount of futures option premium collected. For this reason, most retail futures options traders are call and put buyers.
24-Hour Liquid Markets – How often have you seen a news event after market hours or over the weekend and wished you could trade that news before the stock market opens on Monday? Many futures option markets trade 24 hours a day six days a week starting on Sunday night through to Friday’s close. Futures Options are actively traded, and the large number of traders generally ensures tight bid-ask spreads, fair transparent pricing and trades can be executed without wild price fluctuations.
Leverage – Futures are traded on margin and futures options buying allows you to control a larger futures position with less capital than trading the futures directly. This can result in much greater profits gained with less capital required. However, this increase in profit potential comes with an equally greater risk of substantial losses. Always have appropriate risk management in place to guard against a big move against your futures position.
Tax Benefits – Futures option traders benefit from a more favorable tax treatment than short-term stock traders; 60 percent of futures options trading profits are taxed as long-term capital gains regardless of how long the trade was open, and the remaining 40 percent of profits are taxed as short-term capital gains. Currently the maximum long-term capital gains rate is 15 or 20 percent, and the maximum short-term capital gains rate is 37 percent. Always check with your tax professional for the current tax rates and how any trading will affect your tax return filings.
Pure Market Exposure – A stock or Exchange Traded Fund (ETF) option trader seeking exposure to crude oil would have a number of challenges. Oil refining stocks are highly diversified beyond crude oil, an ETF like USO uses futures and swaps to create a crude oil price proxy and often these instruments do not directly reflect the price action of the crude oil market. On the other hand, the crude oil futures option trader receives pure exposure to the crude oil market. Each crude oil futures option controls one crude oil future made up of 1,000 barrels of West Texas Intermediate crude oil.
What You Need to Know About Trading Futures Options
Trading futures options requires you learn how to trade futures, how to trade options and how to trade futures options. You need a detailed understanding of each futures option contract you are going to trade, learn what drives futures and options prices, and learn how to decide which futures options contracts to buy and sell.
Experienced futures options traders always have a plan before entering a trade. This plan includes how many contracts to buy or sell, how much risk they are willing to take, how much money they are willing to lose on a single trade and at which price level to take profits.
Understanding how futures options trading works is a key factor to consistent trading and avoiding mistakes. Each type of futures options contract has its own unique contract specifications which you need to fully understand – futures options can trade at odd times during the day, each future options has a specific and unique expiration day often different than the underlying future and each futures options contract has the same point value as the underlying future which determines the profit and loss of a position based on the price action.
Finally, if you are currently trading stock options or index options, then you probably already have a good grasp of how futures options work, but there are also some differences you should understand. Take a look at the PDF Adding Futures Options to Your Trading.
To learn more about futures options trading, visit our Resources Page.