Although options trading may seem complicated, these powerful instruments offer a unique way to enhance and diversify a trader’s portfolio. Once some fundamental concepts are understood, options trading can be an effective way for investors to broaden and balance market exposure.
Much like stock options, options on futures afford owners the right, but not the obligation, to buy or sell a particular futures contract at a specific price on or before the option’s expiration date. The main difference is an option on futures, or futures option, is a derivative security of derivative security.
There are two types of options for both the long and short side of trading: call options and put options.
Call vs Put Options
To “go long” on a futures contract, a trader would buy a call option and anticipate a rise in value of the underlying futures vehicle.
To “go short” on a futures contract, a trader would buy a put option and anticipate a decrease in value of the underlying futures vehicle.
With both call and put options, the buyer has no obligation to buy or sell at the specified price, but the opportunity to do so is available until expiration.
Key Terms for Options on Futures Traders
- Exercise Price: The exercise price, or strike price, is the price at which the option buyer or seller may purchase or sell the underlying futures contract.
- Expiration Date: The last day an option can be exercised into the underlying futures contract is referred to as the expiration date, or last trading day. After expiration an options buyer can no longer exercise the option, and an options seller has no obligation.
- Premium: The premium is the price paid for the rights transferred by an option. Factors which influence options premiums include exercise price in relation to corresponding futures price, time remaining to expiration, market volatility and interest rates.
- Offset: Liquidating an option prior to expiration is known as offsetting. Options which have been previously purchased or written can be offset at any time before the expiration date.
- Performance Bond: While options buyers are only required to pay the premium, options sellers or writers are required to post performance bond margin. This is required by options brokers, similar to the performance bond margin required for holding a futures position.
Trading options on futures carries significant risk and traders should appropriately manage exposure to unpredictable markets.
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