Options On Futures

What are Futures Options?

Futures options (Options on Futures) refer to financial derivatives that combine the features of futures contracts and options contracts, based on the future delivery and rights selection of the underlying assets of futures contracts (such as commodities, indices, exchange rates, etc.).

Futures options grant the holder the right to buy or sell the underlying asset at a specific price on or before a specified date in the future. In futures options, the holder can choose to exercise the option on the agreed future date to buy or sell the corresponding futures contract. However, the right in futures options is not mandatory to exercise; under certain special circumstances, the holder may choose to forgo this right.

Characteristics of Futures Options

Emerging as a new financial derivative in the United States in the 1980s, futures options have the following characteristics.

1. Choice of Rights: Futures options give the holder the ability to choose whether to exercise the option based on market conditions and investment strategies.
2. Rights and Obligations: Unlike futures contracts, holders of futures options can choose whether to exercise the option and are not obliged to fulfill the contract.
3. Underlying Asset: The underlying asset of futures options is usually a futures contract, allowing the holder to buy or sell the corresponding futures contract at a specific price on a specific date.
4. Expiry Time: Futures options have a fixed expiry time, i.e., the validity period of the option.
5. Strike Price: The strike price of a futures option is predetermined when the option is purchased, indicating the price at which the holder can buy or sell the underlying asset.
6. Option Premium: Both parties in a futures option transaction need to pay an option premium. The premium depends on factors such as the price of the option contract, the expiration time, and the volatility of the underlying asset's price. The strike price can be either fixed or variable based on market conditions.
7. Risk Management Tool: Futures options can be used as a risk management tool to help investors hedge and manage risks arising from price fluctuations.
8. Leverage Effect: Similar to futures contracts, futures options also have a leverage effect. Since the cost of an option is relatively low, investors can control a larger value of the underlying asset by paying a small premium.

Types of Futures Options

According to different characteristics and applicable ranges, futures options can be divided into the following types.

1. Call Option: A call option grants the holder the right to buy the underlying asset at an agreed price on or before a specific date. When the price of the underlying asset rises, the holder can exercise the option to buy the asset at the agreed price and gain profit.
2. Put Option: A put option grants the holder the right to sell the underlying asset at an agreed price on or before a specific date. When the price of the underlying asset falls, the holder can exercise the option to sell the asset at the agreed price and gain profit.
3. European Option: A European option can only be exercised on the expiry date to buy or sell the underlying asset at the agreed price.
4. American Option: An American option allows the holder to buy or sell the underlying asset at the agreed price at any time during the option's validity period.
5. Asian Option: The strike price of an Asian option is based on the average price or index price of the underlying asset over a certain period. Compared to European and American options, the strike price of an Asian option has a smoothing effect.
6. Bermuda Option: A Bermuda option is a hybrid between European and American options, allowing the holder to buy or sell the underlying asset at the agreed price on specific dates or times.

The above are just some common types of futures options. In fact, there are other special forms of options, such as conditional options and multiple options.

Key Aspects of Futures Options

Investors participating in futures options trading should understand and become familiar with the main aspects of the contract. Here are the key aspects of futures options.

1. Underlying Asset: Futures options are based on a specific underlying asset, which can be various types of futures contracts, such as commodity futures, stock index futures, and forex futures.
2. Strike Price: The futures option contract specifies a particular strike price, also known as the exercise price or agreed-upon price. The strike price can be fixed or variable based on market conditions.
3. Expiration Date: Futures option contracts have a fixed expiration date, also known as the expiry time. The holder can choose whether to exercise the option before the expiration date. Options will automatically expire after the expiration date.
4. Option Type: Futures options can be call options or put options. Call options grant the holder the right to buy the underlying asset at a specific price, while put options grant the holder the right to sell the underlying asset at a specific price.
5. Option Premium: Both parties in a futures options transaction need to pay an option premium, also known as the option fee. The premium is determined based on factors such as the price of the option contract, the expiration time, and the volatility of the underlying asset's price.
6. Contract Specifications: Futures options contracts typically include specifications such as contract units and minimum price fluctuation units, which define the specific details and constraints of option trading.
7. Choice of Rights: Futures options grant the holder the right to exercise the option on specific dates or times. The holder can choose whether to exercise the option based on market conditions and investment strategies.

Differences Between Futures Options and Other Options

Different types of options vary in trading characteristics, contract specifications, market liquidity, and risk management. The key differences are as follows.

1. Underlying Asset: The underlying asset of futures options is usually a futures contract, such as commodity futures, stock index futures, and forex futures. Other options' underlying assets can be stocks, bonds, indices, currencies, etc.
2. Trading Characteristics: Futures options trading generally takes place on exchanges, regulated and standardized by the exchange. Other options may trade in the over-the-counter market, with terms directly negotiated between the contracting parties.
3. Contract Specifications: Futures options' contract specifications are typically standardized and uniform, with the exchange defining details such as contract units and minimum price fluctuation units. Other options' contract specifications may be more flexible and customized based on requirements.
4. Settlement Method: The settlement method for futures options is generally cash settlement, where the holder settles profit or loss based on the difference between the strike price and the underlying asset price. Other options may have different settlement methods, such as physical delivery or cash settlement.
5. Choice of Rights: Futures options grant the holder the right to exercise the option on specific dates or times. Other options also grant similar rights, but the exercise times and methods may vary.
6. Market Liquidity: As exchange-traded financial products, futures options usually have high market liquidity and trading activity. The market liquidity of other options may vary depending on the trading venue, underlying assets, and other factors.
7. Risk Management: Futures options are often used as risk management tools, allowing investors to hedge risks by buying or selling futures options. Other options can also be used for risk management, with investors choosing the appropriate option strategy based on specific situations.