Options on futures
Futures contract is the underlying instrument on which options on futures trade. Options differ considerably for futures. Options can be of immense importance, especially in attempting to preserve the value of an existing fixed-income portfolio.
The reasons for using options on futures are reflected in the structure of an option contract.
An option, when purchased, gives the buyer the right, but not the obligation, to buy or sell a specific amount of a specific commodity at a specific price within a specific period of time. A futures contract requires a buyer or seller to perform under the terms of the contract if an open position is not offset before expiration. The decision to exercise the option is entirely that of the buyer. The purchaser of the option can lose no more than the initial amount of money invested. That is not the case however, for the buyer of a futures contract. An option buyer is never subject to margin calls. This enables the purchaser to maintain a market position, despite any adverse moves without putting up additional funds.
What are Options on Futures Contracts?
Options on futures have the same basic characteristics as stock options except that the underlying asset is a futures contract involving a commodity or financial instrument instead of shares of stock.
Options on futures are traded at the same exchanges that trade the futures contracts and are standardized with respect to the quantity of the underlying futures contracts, expiration date and strike price. An option has only an initial value that declines as time passes. It may even expire worthless, or the holder may have to exercise it in order to recover some value before expiration.
An easy way to understand options on futures is by looking at a quotes table of the prices of S & P 500 futures and the prices of the corresponding options on futures. The principle of the pricing of S & P futures is the same as that of the price behavior of any stock. You want to buy low and sell high. If the S & P futures rise, the value of the contract rises and vice versa if the price of S & P futures fall.
There is a key difference between futures and stock options. A one-dollar change in a stock option is equivalent to $1.00 (per share), which is uniform for all stocks. With S & P futures, a one-dollar change in price is worth $250 (per contract), and this is not uniform for all futures and futures options markets.
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