What Are Options on Futures & How Do They Work? (2024)

FAQs

What Are Options on Futures & How Do They Work? ›

An option on a futures contract gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a strike price on or before the option's expiration date. These work similarly to stock options, but differ in that the underlying security is a futures contract.

Call Options on Futures Example

You decide to buy a call option on wheat futures with a strike price of $5 per bushel that expires in October. The premium for this option is $0.20 per bushel. Each futures contract represents 5,000 bushels, so you pay $1,000 for the option ($0.20 per bushel * 5,000 bushels).

Futures offer higher potential profits but also higher risk, while options provide limited profit potential with capped losses. However, Options require lower upfront capital compared to futures.

The key difference between the two is that futures require the contract holder to buy the underlying asset on a specific date in the future, while options -- as the name implies -- give the contract holder the option of whether to execute the contract.

With an options contract, the buyer agrees to buy the asset only at a fixed price, but is not obligated to do so. It is an option buyer's right to exercise or not exercise the contract. For instance, if any transportation company wants to avoid bearing an unexpected fuel price rise, they can buy futures contracts.

Futures have several advantages over options in the sense that they are often easier to understand and value, have greater margin use, and are often more liquid. Still, futures are themselves more complex than the underlying assets that they track. Be sure to understand all risks involved before trading futures.

Futures contract example

For example, Crude Oil is currently selling at $60 a barrel, and a futures contract for $65 per barrel is available for three months' time. As you believe the price of WTI will rise beyond $65 by the time of expiry, you buy the contract. The market actually rises to $75.

Future contracts have numerous advantages and disadvantages. The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.

While futures can pose unique risks for investors, there are several benefits to futures over trading straight stocks. These advantages include greater leverage, lower trading costs, and longer trading hours.

If you are limited to trading stock or index options, the stock market may be closed when the opportunity strikes and you cannot react until the next trading session. When trading futures, you can usually place a trade in many key markets the moment an opportunity arrives.

What is an example of options trading? ›

Options Trading Example

Suppose, you purchase a long call option for 100 shares of Company X at ₹110 per share for December 1. You'd be entitled to purchase 100 shares at ₹110 per share regardless of the actual price of the share is on December 1.

While both have the same degree of leverage and capital committed, volatility makes futures the riskier of the two. You must understand that leverage can be akin to a “double-edged sword”. You can gain money quickly, and lose it in the blink of an eye.

Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price.2 Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Overview: Swing trading is an excellent starting point for beginners. It strikes a balance between the fast-paced day trading and long-term investing.

A Future is a right and an obligation to buy or sell an underlying asset at a predetermined price. Options are a right without an obligation to buy or sell equity or index. While a Call Option is a right to buy while a Put Option is a right to sell. Options and Futures are conceptually different but intrinsically same.

Options on futures are contracts that represent the right, not the obligation, to either buy (go long) or sell (go short) a particular underlying futures contract at a specified price on or before a specified date, the expiration date.

The buyer of a futures-style option does not pay the option premium at the initiation of the transaction. Rather, during the life of the option (including initiation and the exercise days), he pays (receives) any decrease (increase) in the option's premium as a margin.

Some of the types of financial futures include stock, index, currency and interest futures. There are also futures for various commodities, like agricultural products, gold, oil, cotton, oilseed, and so on.

Options are derivatives of financial securities—their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, forwards, swaps, and mortgage-backed securities, among others.