Futures Option

Definition

A futures option is a type of financial derivative instrument. It provides the buyer the right, but not the obligation, to purchase or sell a futures contract at a specified price (strike price) within a specified time frame. The two primary types of futures options are Call Options and Put Options.

Call Option: Gives the holder the right to buy a futures contract.
Put Option: Gives the holder the right to sell a futures contract.

These options are used by traders to hedge against risks or to speculate on the price movements of the underlying asset, which can include commodities (like oil or gold), currencies, or financial instruments (like government bonds or stock indices).

Examples

Commodity Trading: A farmer concerned about a potential decrease in the price of wheat can purchase a put option. If wheat prices fall, the put option increases in value, offsetting the decreased revenue from selling the wheat in the spot market.
Financial Futures: An investor might buy a call option on S&P 500 futures if they anticipate a rise in the stock market. If the market does rise, the call option gains value, providing a leveraged return on the initial investment.
Hedging Currencies: A U.S. company expecting a payment in euros in six months might buy a call option on euro futures to hedge against the risk of the euro strengthening against the dollar.

Frequently Asked Questions

What is the main purpose of trading futures options?

Futures options are primarily used for two purposes: hedging risk and speculating on price movements. Hedgers use futures options to protect against potential adverse price movements in underlying assets. Speculators aim to profit from price changes without needing to own the underlying asset.

How does a futures option differ from a futures contract?

A futures option gives the right but not the obligation to enter into a futures contract, whereas a futures contract obligates both parties to transact the underlying asset at a future date, at the agreed-upon price.

What is the expiration date in the context of futures options?

The expiration date is the last day on which the futures option can be exercised. After this date, the option becomes void.

Are there risks associated with trading futures options?

Yes, risks include the potential loss of the premium paid for the option, as well as liquidity risks and market volatility, which can lead to substantial financial losses.

Can a futures option be sold before its expiration?

Yes, a futures option can be sold before its expiration date. Options traders often close their positions early to realize profits or cut losses instead of waiting until expiration.

Futures Contract

A legally binding agreement to buy or sell a specific quantity of a commodity or financial asset at a predetermined price on a set future date.

Call Option

A financial contract giving the buyer the right, but not the obligation, to purchase an underlying asset at a specified strike price within a specified time period.

Put Option

A financial contract giving the buyer the right, but not the obligation, to sell an underlying asset at a specified strike price within a specified time period.

Hedging

The practice of making an investment to reduce the risk of adverse price movements in an asset, typically by taking an offsetting position in a related security such as an option or futures contract.

Online References

Suggested Books for Further Studies

“Options, Futures, and Other Derivatives” by John C. Hull
“Trading Options as a Professional: Techniques for Market Makers and Experienced Traders” by James Bittman
“Fundamentals of Futures and Options Markets” by John C. Hull
“Options on Futures: New Trading Strategies” by John F. Summa and Jonathan W. Lubow

Fundamentals of Futures Options: Derivatives Trading Basics Quiz

### What is a futures option? - [ ] An obligation to buy a futures contract. - [x] The right but not the obligation to buy or sell a futures contract. - [ ] A guarantee of future profits. - [ ] An insurance policy. > **Explanation:** A futures option grants the holder the right, but not the obligation, to buy or sell a futures contract at a predetermined price before its expiration. ### What are the two primary types of futures options? - [x] Call options and put options. - [ ] Equity options and bond options. - [ ] Commodity options and currency options. - [ ] Retail options and institutional options. > **Explanation:** The two primary types of futures options are call options, which give the right to buy, and put options, which give the right to sell a futures contract. ### What is the primary use of futures options in commodity trading? - [ ] To increase production. - [x] Hedging risk against price fluctuations. - [ ] Securing loans. - [ ] Speculating on weather changes. > **Explanation:** In commodity trading, futures options are primarily used for hedging risk against adverse price movements in the underlying asset. ### Can a futures option be exercised after its expiration date? - [x] No, it becomes void after expiration. - [ ] Yes, if both parties agree. - [ ] No, unless it is a special case approved by the exchange. - [ ] Yes, but only up to two days after expiration. > **Explanation:** Futures options cannot be exercised after their expiration date as they become void. ### How can an investor profit from a call option if the market rises? - [ ] By holding onto the call option. - [x] By exercising the option and securing the underlying futures contract at the lower strike price. - [ ] By buying more futures options. - [ ] By selling the underlying futures contract. > **Explanation:** An investor profits from a call option in a rising market by exercising the option and buying the underlying futures contract at the predetermined strike price, which is lower than the current market price. ### What does the 'strike price' in a futures option refer to? - [ ] The current market price. - [x] The predetermined price at which the option can be exercised. - [ ] The price at which the option was purchased. - [ ] The closing price of the previous day. > **Explanation:** The strike price is the predetermined price at which the holder of the futures option can buy or sell the underlying futures contract. ### Which regulatory body oversees futures and options trading in the United States? - [ ] Federal Reserve - [x] Commodity Futures Trading Commission (CFTC) - [ ] Securities and Exchange Commission (SEC) - [ ] Financial Industry Regulatory Authority (FINRA) > **Explanation:** The Commodity Futures Trading Commission (CFTC) oversees futures and options trading within the United States. ### What is the cost paid for purchasing a futures option called? - [x] Premium - [ ] Strike price - [ ] Margin - [ ] Commission > **Explanation:** The cost paid for purchasing a futures option is referred to as the premium. ### What is the primary risk if the holder of a futures option does not exercise the option? - [ ] Increased leverage. - [ ] Unlimited liability. - [x] Loss of the premium paid. - [ ] Obligation to buy the underlying asset. > **Explanation:** The primary risk if the holder does not exercise the futures option is the loss of the premium paid for the option. ### Why might a futures options trader close their position before expiration? - [x] To realize profits or cut losses early. - [ ] To avoid paying commissions. - [ ] To evade regulations. - [ ] Because options cannot be held until expiration. > **Explanation:** Traders might close their futures options positions before expiration to realize profits or cut losses without waiting for the option to expiry.

Thank you for exploring the multifaceted world of futures options and testing your knowledge with our introductory quiz. Continue delving into derivatives markets for greater expertise!