Options on futures, or futures options, are similar to stock options except that the underlying instrument is a futures contract. A futures option consists of the right but not obligation to buy or sell a particular futures contract at a specific price and before a certain date.
How Are the Costs of Options on Futures Determined?
The price of an option on a futures contract, or premium, is paid by the buyer of an option and is collected by the seller of an option. Since options on futures are derivatives of derivatives, the pricing structure is slightly more complex.
While supply and demand are the main driving force on the price of premiums, other factors include:
- Volatility of the underlying futures market – Volatility is defined as price movement which occurs rapidly and unpredictably. The higher the volatility, the more options premiums will increase. If the underlying futures contract is experiencing high volatility, generally this will cause premiums to rise as option buyers are willing to pay higher premiums for more protection.
Exercise price in respect to the underlying futures price – The relationship between an options exercise price, or strike price, and the price of the underlying futures derivative plays an important part in the pricing of option premiums. The larger the difference in price, the higher the premium will be.
- Example: If WTI Crude Oil Futures (CL) are trading at $60 per barrel, a $54 call option would cost more than a $58 call option, as the right to buy oil $4 per barrel cheaper would be more expensive.
- Time remaining until an option’s expiration – As an option’s expiration date nears, its value decays. An option with more time until expiration will have a greater intrinsic value than an option less time left to expiration.
Options on Futures Pricing Concepts
In-the-Money: When the futures price exceeds the exercise price of a call option, the option is in-the-money. Likewise, a put option is said to be in-the-money when the futures price is below the strike price of the option.
Out-of-the-Money: Opposite of in-the-money, call options are out-of-the money when the futures price is less than the option’s price. Conversely, put options are out-of-the-money when the futures price is above the option’s exercise price.
At-the-Money: Both call and put options are said to be at-the-money when the underlying futures price is equal to the strike price.
Delta: Delta refers to the rate of change of a futures option’s price versus the underlying futures’ rate of change. The delta is calculated by options pricing software at the exchange.
Time Value Decay: As previously mentioned, the value of an option erodes as its expiration date nears. Time value, also referred to as extrinsic value, is the value of an option beyond its intrinsic value. The time value of a futures option decays as each day passes and accelerates closer to expiration. This concept is also referred to as time decay.
Leverage: By design, options provide leverage to a buyer. However, since futures options are a derivative of an already leveraged trading vehicle, a spike in volatility presents a much greater risk and reward scenario.
Traders should always employ proper risk-management measures when trading volatile markets.
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