An option on a futures contract is the right, but not the obligation, to buy or sell the underlying futures contract at a predetermined price on or before a given date in the future.
- Options can be used like insurance policies to limit losses on a futures contract.
- They can also be used for speculative purposes, whether you are selling options to receive premium income or using options to establish a position in a particular commodity, index or interest rate.
- As hedging instruments, options can produce offsetting gains in the face of adverse price changes in the cash market.
- Options permit you to efficiently deploy capital, in the form of option premium. In this case, you can participate in the price movements of the underlying asset, without having to buy the asset outright.
Understanding Option Contract Details
Contract details refer to the terms of an option contract. How an option contract gains or loses value, and therefore creates a benefit to you as the holder of the option, is dependent on key option contract details. Understanding the key contract details is essential to determining how and when an option will meet your financial objectives. Choosing the right options contract for you is dependent on your objectives. For example, if you want to protect or hedge an asset, you will need to know the contract details to determine the best fit for your portfolio; when speculating, your trading strategy might be influenced by the contract details.
Key Option Elements
The deliverable for every CME Group option is a futures contract. This is called the “underlying instrument” or the “underlier”. Futures contracts also have an underlying product such as an interest rate, equity index, a foreign currency rate, or some other commodity.
Each option also has its own expiration or maturity date. This is the last day on which an option can be exercised into the underlying futures contract. After the expiration or maturity date, the option contract will cease to exist; the buyer cannot exercise and the seller has no obligation.
This is the agreed price at which a transaction will happen, if the option is worth exercising. The strike price for the option contract will determine the value at expiration.
Option contracts fall into two categories, call options and put options.
A call option is the right to “buy” the underlying product at a predetermined price.
A put option is the right to “sell” the underlying product at a predetermined price.
Before establishing your option position, you will need to carefully consider your financial strategy and objectives. Whether you are hedging or pursuing a trading strategy, close alignment of the contract details are important to achieving desired results from your option position.
What is Exercise Price (Strike)?
One key characteristic of an option contract is the agreed upon price, known as the strike price or exercise price.
The strike price is the predetermined price at which you buy (in the case of a call) or you sell (in the case of a put) an underlying futures contract when the option is exercised.
Strike Price Ranges
When trading options you can choose from a range of strike prices that are set at predefined intervals by the exchange. The interval range may vary depending on the underlying futures contract.
While futures can trade at prices in between these intervals, the exchange attempts to set the option strike intervals to meet the market’s need for liquidity and granularity.
Each option product will have a unique price interval rule that is based on the product structure and the needs of the market. Not only will products have varying intervals, but also within certain products, the intervals will change depending on the expiration month.
For example, options on corn futures have an interval of 5 cents for the two front months, of the expiring futures contract and then transition to 10 cent intervals for contracts 3 months and beyond.
The full range of strike prices, for many options products, will be determined by the previous day’s daily settlement price for the futures contract.
Over time the entire range may expand beyond the initial listed boundaries, due to large market movements. In addition, strike intervals can become more granular as options move closer to expiration.
What is Expiration Date (Expiry)?
Options do not last forever. They expire or terminate; they all have an ending date.
Options are tied to an underlying futures product and all futures products have a settlement date. If the futures contract no longer exists, then clearly an option on that contract can no longer exist either.
When do options expire?
When it comes to options on futures, there may be a variety of option expiration dates you could trade for the same futures contract.
You may find some option expirations align with the expiration of the underlying futures contract. In other cases a futures product could have a variety of shorter term options listed. These shorter term options offer traders greater precision and flexibility to expand their trading strategies.
What is a Call Option?
A call option is the right to buy the underlying futures contract at a certain price.
When traders buy a futures contract they profit when the market moves higher. The call option has a similar profit potential to a long futures contract. When prices move upward the call owner can exercise the option to buy the future at the original strike price. This is why the call will have the same profit potential as the underlying futures contract.
However, when prices move down you are not obligated to buy the future at the strike price, which is now higher than the futures price because that would create an immediate loss.
With this downside protection why would any trader buy a futures contract instead of call?
The potential to profit on a call option does not come without a cost. The seller or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a call option pays a premium to the seller of a call option.
As a result of the added cost of the premium, the profit potential for a call is less than the profit potential of a futures contract by the amount of premium paid. The price of the future must rise enough to cover the original premium for the trade to be profitable. Moreover, options premiums are impacted by time decay and changes in volatility (futures are not).
The breakeven point for a call is the strike price plus the premium paid. So if you paid 4.50 points for a 100 call option, the breakeven is 104.50. The most you could lose is the premium or 4.50 points.
For every long call option buyer, there is a corresponding call option “writer” or seller. If you sell the call option, then you receive the premium in return for the accepting the risk, that you may need to deliver a futures contract, at a price lower than the current market price for that future.
Option sellers have unlimited risk if the futures price continues to rise.
Call sellers will profit as long as the futures price does not increase beyond the value of the premium received from the buyer.
The breakeven point is exactly the same for the call seller as it is for the call buyer.
Explaining Put Options (Short and Long)
A put option is the right to sell the underlying futures contract at a certain price.
When traders sell a futures contract they profit when the market moves lower. A put option has a similar profit potential to a short future. When prices move downward the put owner can exercise the option to sell the futures contract at the original strike price. This is when the put will have the same profit potential as the underlying futures.
However, when prices move up you are not obligated to sell the future at the strike price, which is now lower than the futures price because that would create an immediate loss.
Why would any trader short a future instead of buying a put?
The potential to profit on a put option does not come without a cost. The “seller” or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a put option pays a premium to the seller of a put option.
As a result of the added cost of the premium, the profit potential for a put is less than the profit potential of a futures contract by the amount of premium paid. The price of the futures contract must fall enough to cover the original premium for the trade to be profitable.
The breakeven point for a put is where the profit on the futures contract that you can purchase at the strike price is equal to the premium paid for the call.
For every long put option buyer, there is a corresponding put option “writer” or seller. If you have written the put option, then you receive the premium in return for the accepting the risk that you may need to buy a futures contract at a higher price than the current market price for that future.
While Put option sellers don’t have unlimited risk, the risk of writing puts can still be very large. The most a put option seller can lose is the full strike price minus the premium received. If you sell a 100 put option, and the underlying future drops to 20. You will have an 80pt loss minus the premium you took in which will only offset a small portion of the loss. In reality, most futures contracts don’t lose 80 percent of their value as in the example above, but losses on ANY short option can be substantial…so do your homework and fully understand the risks.
Put sellers will profit as long as the futures price does not fall beyond the value of the premium received subtracted from the strike price. For example, if you sell a 100 put strike and receive a premium of 6.00 pts. You will profit as long as the future is above 94 (strike minus the put premium).
Option Expiration: A.M. or P.M.
Every option contract has a specific expiration date, and time. The time of expiration can be either in the morning (a.m.) or in the afternoon (p.m.).
Options that expire at the close of the market are considered p.m. and options that expire the morning of the last trading day are a.m.
The vast majority of options on futures expire at the close of the market on the last trading day, but there are notable exceptions. Options with a.m. expiration are generally written on a future contract that has the same expiration date and time. Futures that are financially settled, meaning they settle to cash payments rather than physical commodities, are often settled using a.m. expiration.