Underlying Futures Contract

Underlying Futures Contract Futures Contract Options Treasury Bond Futures Chicago Board of Trade Financial Derivatives
An underlying futures contract is the specific futures contract that serves as the basis for an option on that future. For example, an option on a U.S. Treasury bond futures contract at the Chicago Board of Trade (CBOT) would have the Treasury bond futures contract as its underlying future.
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Definition

An underlying futures contract refers to the specific type of futures contract that is associated with and underpins an option. In financial markets, particularly within futures and options trading, the value of an option derives from the value of its underlying asset, which can range from commodities to financial instruments like bonds. The underlying future is crucial as it determines the terms and prices upon which the option is based.

For instance, on the Chicago Board of Trade (CBOT), there are options that utilize U.S. Treasury bond futures contracts as their underlying futures. In these instances, the Treasury bond futures contract represents the core asset upon which the associated options are constructed.

Examples

  1. U.S. Treasury Bond Futures Option: The CBOT offers options on U.S. Treasury bond futures. Here, the underlying futures contract is the Treasury bond futures.
  2. Gold Futures Option: On the COMEX (Commodity Exchange), options on gold futures are offered, where the underlying futures contract is the gold futures contract.
  3. Crude Oil Futures Option: The NYMEX (New York Mercantile Exchange) provides options on crude oil futures, with the underlying futures contract being the crude oil futures contract.

Frequently Asked Questions

Q1. What is the significance of the underlying futures contract in options trading? A1. The underlying futures contract determines the value and price behavior of the option. It is essential for setting the strike prices and expiration dates irrelevant to the underlying asset’s performance.

Q2. How do traders use underlying futures contracts in their strategies? A2. Traders use the underlying futures to hedge risks or speculate on price movements. For instance, instead of trading the futures directly, they may choose options to limit potential losses.

Q3. Are underlying futures contracts only related to commodity markets? A3. No, underlying futures contracts can also be based on financial instruments such as treasury bonds, stock indexes, and currencies.

  • Futures Contract: An agreement to buy or sell an asset at a future date at a predetermined price.

  • Option: A financial derivative giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a set price within a specific period.

  • Strike Price: The predetermined price at which an option can be exercised.

  • Chicago Board of Trade (CBOT): One of the oldest futures and options trading exchanges, which offers a variety of derivative instruments.

Online References

  1. Investopedia: Futures Contract
  2. CME Group: Options on Futures
  3. Investopedia: Options
  4. Chicago Board of Trade

Suggested Books for Further Studies

  1. “Option Volatility and Pricing” by Sheldon Natenberg
  2. “Fundamentals of Futures and Options Markets” by John C. Hull
  3. “Trading Options Greeks: How Time, Volatility, and Other Pricing Factors Drive Profit” by Dan Passarelli
  4. “Futures, Options, and Swaps” by Robert W. Kolb, James A. Overdahl

Fundamentals of Underlying Futures Contract: Financial Derivatives Basics Quiz

### What is an underlying futures contract? - [ ] A direct trade of commodities. - [ ] A contract for immediate purchase. - [x] A futures contract that forms the basis of an option. - [ ] A mutual fund. > **Explanation:** An underlying futures contract is a futures contract that forms the basis of an option, determining the characteristics and value of that option. ### Can an underlying futures contract be based on financial instruments? - [x] Yes, it can be based on financial instruments like treasury bonds. - [ ] No, it is only based on physical commodities. - [ ] It is only applicable to stock options. - [ ] It involves foreign currencies only. > **Explanation:** Underlying futures contracts can be based on various financial instruments including treasury bonds, stock indexes, and currencies. ### Which of the following exchanges offers U.S. Treasury bond futures options? - [x] Chicago Board of Trade (CBOT) - [ ] New York Stock Exchange (NYSE) - [ ] Nasdaq - [ ] Tokyo Stock Exchange (TSE) > **Explanation:** The Chicago Board of Trade (CBOT) offers options on U.S. Treasury bond futures. ### In options trading, what does the strike price represent? - [ ] The estimated value of the stock index. - [x] The predetermined price at which an option can be bought or sold. - [ ] The stock's current market price. - [ ] The interest rate for futures contracts. > **Explanation:** The strike price represents the predetermined price at which an option can be exercised. It is set at the time of the option's establishment. ### Why might an investor choose options over trading the underlying futures contract directly? - [ ] The strike price is higher. - [ ] Shorter transaction time. - [x] To limit potential losses. - [ ] Guaranteed profits. > **Explanation:** Investors might choose options to limit potential losses, as purchasing options imposes a maximum potential loss equivalent to the premium paid. ### What role does the underlying futures contract play in setting options terms? - [ ] It provides the historical data for analysis. - [x] It determines the option's strike price and expiration date. - [ ] It guarantees the option's profit. - [ ] It calculates the option's margin requirements. > **Explanation:** The underlying futures contract determines the option's strike price and expiration date, ensuring alignment with the futures market. ### Which book would be most helpful for someone new to futures and options? - [x] "Fundamentals of Futures and Options Markets" by John C. Hull - [ ] "Economics" by Paul Samuelson - [ ] "The Random Walk Guide to Investing" by Burton G. Malkiel - [ ] "Security Analysis" by Benjamin Graham > **Explanation:** "Fundamentals of Futures and Options Markets" by John C. Hull provides a comprehensive introduction to the topic, making it ideal for beginners. ### Are options on futures limited to a specific exchange? - [ ] Yes, each type of future only trades options on one exchange. - [ ] Yes, options on futures are exclusive to New York Stock Exchange. - [x] No, different exchanges offer options on different futures. - [ ] Yes, but only in North America. > **Explanation:** Different exchanges globally offer options on various futures, such as CBOT, NYMEX, and COMEX. ### What is the difference between an option and the underlying futures contract? - [x] An option grants the right but not the obligation to trade the future; the futures contract is an obligation. - [ ] Both are obligations to trade assets at a future date. - [ ] Futures contracts are for immediate trades; options are deferred. - [ ] Options require higher margin requirements than futures. > **Explanation:** An option grants the holder the right but not the obligation to buy or sell the underlying asset, whereas a futures contract involves an obligation. ### What type of trader would most benefit from utilizing options on futures? - [ ] Only long-term investors. - [x] Traders looking to hedge risks. - [ ] Only high-frequency traders. - [ ] Those looking to diversify bond portfolios. > **Explanation:** Traders looking to hedge risks often utilize options on futures as they provide a method to manage potential losses while participating in price movements.

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