What are Futures Options?

In this Guide we will look at what futures and futures options are and why are they important for any trader.

Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. The asset involved can be a physical commodity or a financial instrument. For example a futures contract on Oil gives us exposure to 1000 barrels of oil at an expiration date in the future.

Futures have now expanded to include metals, energy, currencies, equity indexes and interest rate products, all of which are also traded electronically.

Who trades Futures?

Futures traders are divided into two main categories:

• Hedgers who use the futures market to manage price risk. For example an airline company like Delta Airlines uses Futures on Oil to protect themselves against price appreciation of the commodity they need to run their operations.
• Speculators that use futures to increase their profits by benefiting from the leverage that futures provide.

Futures markets are crucial for hedgers to manage their exposure to price risks, but they wouldn’t function effectively without the involvement of speculators. These participants provide much of the market’s liquidity, enabling hedgers to efficiently enter and exit positions. Speculators range from full-time professional traders to individuals who trade sporadically.

What are Futures Options?

Future options are a type of financial derivative that grants the holder the right, but not the obligation, to buy or sell a futures contract at a predetermined price within a specified timeframe. 

These options combine features of futures contracts and standard options, allowing investors and traders to speculate on or hedge against future price movements of various assets, including commodities, currencies, and financial instruments. 

Like all options, come in two forms: Calls and Puts. Each has a strike price and an expiration date. 

These options can be exercised anytime before expiration if they are American-style, or only at expiration if they are European-style. Upon exercise, the holder takes a position in the underlying futures contract, which can then be held to maturity, closed out early, or allowed to settle.

These are similar to options that have the SPX as the underlying. The only difference is that in the case of future options, the underlying is the futures contract. Futures Options give us exposure to 1 future contract. 

Advantages of Futures Options

There are some key advantages of using futures options.

• Flexibility. Traders can use various strategies involving futures options, including buying calls, buying puts, writing calls, and writing puts, among others. Each strategy serves different market outlooks, from bullish to bearish and even neutral strategies.
• Leverage. Like futures, options on futures offer the possibility of high returns due to the leverage they provide. 
• 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 paid.

How do Futures Options work?

Now let’s break down how futures options work.

Consider buying a futures contract on crude oil. This contract commits you to purchasing a set amount of oil—typically 1,000 barrels—at a predetermined price on a future date. Imagine the price per barrel to be around $90, this would give you an exposure per contract of $90.000. If the price moves by 1 point your profit or loss is $1000. 

As you might imagine, this can be daunting for retail investors due to the significant exposure and potential for substantial losses.

24/5 Trading

Now let’s discuss why Futures options are so important and the difference between spot options. 

First, consider the 24/5 trading capability. Futures markets operate around the clock for five days a week, facilitated by exchanges such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).

What is the advantage of 24/5 trading?

Global events don’t wait for market hours. With 24/5 trading, investors can immediately react to international developments and economic news anytime they occur. This flexibility allows traders from different time zones to engage the market when it suits them best, enhancing liquidity and participation.

Consider the impact of key economic indicators like the CPI data, released at 8:30 AM Eastern Time—before the market opens at 9:30 AM EST.

The same principle applies to after market trading. When a company like Apple or Microsoft releases their earnings they typically do it after the market is closed.

Futures options enable trading on this information before the next day’s market opening, avoiding the risks associated with price gaps at the open.

If a big company has a bullish earnings release the index future typically tends to move very fast. Microsoft, Google, Apple, and Tesla account for about 18% of the S&P 500 and about 25% of the NASDAQ. So a strong move on the price of these companies will move the market. With futures options you can capitalize on this.

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