Futures contracts have been traded on U.S. exchanges since 1865, options on futures contracts were not introduced until 1982. Initially offe red as part of a government pilot program, their success eventually led to widespread use of options on agricultural as well as financial futures contracts. Options on futures contracts can offer a wide and diverse range of potentially attractive investment opportunities. However, options trading is a speculative investment and should be treated as such. Even though the purchase of options on futures contracts involves a limited risk (losses are limited to the costs of purchasing the option), it is nonetheless possible to lose your entire investment in a short period of time. And for investors w ho sell rather than buy options, there is no limit at all to the size of potential losses.
Options on Futures are also known as “ Futures Options”, are an unique form of derivative instrument as it is a “Derivative on Derivative”. Options on Futures are options that derive their value from another derivative instrument, Futures, which in turn derive their value from an underlying asset such as an index or commodity. Essentially, the futures specified in the option contract allows someone to enter into the specified futures contract when the option expires.
Strike Price : Also known as the “exercise price,” this is the stated price at which the buyer of a call has the right to purchase a specific futures contract or at which the buyer of a put has the right to sell a specific futures contract.
Underlying Contract : This is the specific futures contract that the option conveys the right to buy (in the case of a call) or sell (in the case of a put).
Option Buyer : The option buyer is the person w ho acquires the rights conveyed by the option: the right to purchase the underlying futures contract if the option is a call or the right to sell the underlying futures contract if the option is a put.
Option Seller ( Writer) : The option seller (also know n as the option writer or option grantor) is the party that conveys the option rights to the option buyer.
Option price/premium: It is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price or the exercise price.
American options: These can be exercised at any time upto the expiration date.
European options: These can be exercised only on the expiration date itself. European options are easier to analyze than American options and properties of an American option are frequently deduced from those of its European counterpart.
In-the-money option: An in-the-money (ITM) option would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-themoney when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.
At-the-money option: An at-the-money (ATM) option would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the cur- rent index equals the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option would lead to a nega- tive cash flow if it were exercised immediately. A call option on the index is out-of-the- money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.
Tick Price : In financial markets, a tick size is the smallest increment (tick) by which the price of stocks, futures contracts or other exchange-traded instrument can move. Tick sizes can be fixed or vary according to the current price (common in European markets) with larger increments at higher prices. Heavily-traded stocks are given smaller tick sizes. Span Margin : Options and futures writers are required to have a sufficient amount of
margin in their accounts to cover potential losses. The SPAN system, through its algorithms, sets the margin of each position to its calculated worst possible one-day move. The system, after calculating the margin of each position, can shift any excess margin on existing positions to new positions or existing positions that are short of margin.
Premium : The “price” an option buyer pays and an option writer receives is known as th e premium. Premiums are arrived at through open competition between buyers and sellers according to the rules of the exchange where the options are traded. A basic know ledge of the factors that influence option premiums is important for anyone considering options trading.The premium cost can significantly affect whether you realize a profit or incur a loss.
Expiration : This is the last day on which an option can be either exercised or offset. Be certain you know the exact expiration date of any option you have purchased or written. Options often expire during the month prior to the delivery month of the underlying futures contract. Once an option has expired, it no longer conveys any rights. It cannot be either exercised or offset. In effect, the option rights cease to exist.
Quotations : Premiums for exchange traded options are reported daily in the business pages of most major newspapers, as well as by a number of internet services. With an understanding of terms call, put, strike price and expiration month it is easy to determine the premium for a particular option. Take a look at the following quotation for gold options:
Gold (100 troy ounces; $ per troy ounce) Strike 285 290 295 300 305 310 Calls-Settle Jan Fe b Apr 10.50 10.70 14.80 5.70 1.20 11.40 1.60 4.30 7.90 .40 2.00 5.40 .20 1.20 3.80 .10 .60 2.60 Jan Puts-Settle Price Fe b Apr .20 1.00 2.50 .30 1.80 4.10 1.10 3.80 5.70 4.90 6.50 8.30 9.60 10.60 11.30
14.50 15.10 15.00
Est. Vol.: 4,400 Mn 2,687 calls 5,636 puts Op Int Mon: 273,658 calls 121,133 puts
Market Of Options
1. Grain 2. Oilseeds 3. Livestock 4. Other agricultural products 5. Metals 6. Energy 7. Currencies 8. Financial Instruments
Product Profile: The CME’s S&P 500 Futures Options Contract Size: One S&P 500 stock index futures contract Strike Prices: Generally12 strikes, including the at-the-money strike. Increments between strike price generally are 25 index points. Number of strike prices increases as expiration approaches and increments between strike prices is reduced to a minimum of 5 index points. Tick Size: 1 index points or $25.00. Price Quote: Price is quoted in terms of Standard & Poors 500 Index. Contract Months: Four months in the March, June, September, December cycle plus the first two serial months not in the cycle for a total of 6 contract months. Expiration and final Settlement: Options that expire in the March, June, September, December cycle expire at the same time as the underlying futures contract. The two non-March cycle options expire on the third Friday for the contract month. Trading Hours: Floor: 8:30 a.m. to 3:15 p.m.; Globex: Monday through Thursday 3:30 p.m. to 8:15 a.m. with a shutdown period from 4:30 p.m. to 5:00 p.m. nightly. Sunday and holidays 5:30 p.m. to 8:15 a.m. Daily Price Limit: Trading halted when futures trading is halted
Call Option on Futures Upon exercising a option on futures, the call owner: – – Receives a long position in the underlying futures at the settlement price prevailing at the time of exercise. Receives a payment that equals the settlement price minus the exercise price of the option on futures. The call owner would not exercise if the futures settlement price did not exceed the exercise price. Upon exercise, the call seller: – – Receives a short position in the underlying futures at the settlement price prevailing at the time of exercise. Pays the long trader the futures settlement price minus the exercise price.
Put Option on Futures Upon exercising a option on futures, the put owner: – – Receives a short position in the underlying futures contract at the settlement price prevailing at the time of exercise. Receives a payment that equals the exercise price minus the futures settlement price. The put owner would not exercise unless the exercise price exceeded the futures settlement price. Upon exercise, the put seller: – –
Futures Contract S&P 500
Receives a long position in the underlying futures contract. Pays the exercise price minus the settlement price.
Contract Value $250 x price of S&P 500 Delivery Months March, June, Sept. and Dec. Type of Settlement Cash
Tick Size .10 (a \'dime\') = $25
Last Trading Day Thursday prior to the third Friday of the contract month
S&P futures trade in "dime-sized" ticks (the minimum price change intervals), worth $25 each, so a full point ($1) is equal to $250. The active month is known as the "front-month
contract", and it is the first of the three delivery months. The last trading day for all S&P futures contracts is on the Thursday before expiration, which is on the third Friday of the contract month. By looking at below, we can see some actual prices for the S&P 500 futures, taken from the close of daily trading (pit-session) on Jun12,2002.
Contract June \'02 Sept. \'02 Dec. \'02
High 1022.80 1023.80 1025.00
Low 1002.50 1003.50 1007.00
Settlement 1020.00 1021.00 1023.00
Point Change +6.00 +6.00 +6.00
Settlement prices for June 12, 2002
The Jun S&P futures contract in Figure 2, for example, settled at 1020.00 on this particular day. The point change of +6.00 is equivalent to a gain of $1,500 per single contract (6 x $250 = $1,500). It is worth noting that the S&P futures and the S&P 500 stock index will trade nearly identically, but the S&P futures will trade with a slight premium attached.
Understanding S&P Futures Options
Now let's turn to some of the corresponding options. Like for nearly all options on futures, there is a uniformity of pricing between the futures and options. That is, the value of a $1 change in premium is the same as a $1 change in the futures price. This makes things easy. In the case of S&P 500 futures options and their underlying futures, a $1 change is worth $250. To provide some real examples of this principle, I have selected in Figure 3 the 25-point interval strike prices of some out-of-the-moneyputs and calls trading on the Jun S&P futures. Just as we would expect for stock put and call options, the delta in our examples below is positive for calls and negative for puts. Therefore, since the Jun S&P futures rose by six points (at $250 per point, or dollar), the puts fell in value and the calls rose in value. The strikes farthest from the money (925 put and 1100 call) will have the lower delta values, and those nearest the money (1000 put and 1025 call) have higher delta values. Both the sign and the size of the change in dollar value for each option make this clear. The higher the delta value the greater the option price change will be affected by a change of the underlying S&P futures
For example, we know that the Jun S&P futures rose six points to settle at 1020.20. This settlement price is just shy of the Jun call strike price of 1025, which increased in value by $425. This near-the-money option has a higher delta (delta = 0.40) than options farther from the money, such as the call option with a strike price of 1100 (delta = 0.02), which increased in value by only $12.50. Delta values measure the impact further changes in the underlying S&P futures will have on these option prices. If, for instance, the underlying Jun S&P futures were to rise 10 more points (provided there is no change in time-value decay and volatility), the S&P call option in figure 3 with a strike price of 1025 would rise by four points, or gain $1,000.
The same but reverse logic applies to the S&P put options in Figure 3. Here we see the put option prices declining with a rise in the Jun S&P futures. The nearest-the-money option has a strike price of 1000, and its price fell by $600. Meanwhile, the farther-from-the-money put options, such as the option with a strike price of 925 and delta of -0.04, lost less, a value of $225.
When Options on Futures are exercised, futures contracts exchange hands between the long and the short and when the resultant futures contract expires, the underlying asset is traded between the long and the short of the futures contracts if it is a physically settled futures contract and if it is a cash settled futures contract.