Futures Options Ė Opening New Markets
Futures options are similar to futures themselves in that both give the holder the right to buy or sell the underlying commodity for a specific price on a specific day. Beyond this there are some significant difference between the two and how they are traded.
Rights and Requirements
The main difference between futures options and futures has to do with rights and requirements. Futures options give the holder the right to buy or sell (depending on the option) the underlying commodity for a specific price on a specific date while futures obligate the purchase or sale. While there are investment strategies for futures that eliminate the need for an investor to accept delivery of 10 tons of pork bellies, the basic concept is the same; futures require the buyer to take delivery (in one form or another) of the commodity in question.
Futures Options Contracts
Futures options markets trade options contracts, which specify the underlying asset, the expiration date, and the strike price. Those involved in day trading can trade options contracts to make a profit on the difference between the buying price and the selling price when the options are sold before expiration, or to make a profit from the underlying asset when they are exercised.
As with futures contracts, futures options contracts are traded by day traders and longer term traders in futures markets, and also by non traders with an interest in the underlying commodity. When traded for the underlying commodity, options contracts work the same way as futures contracts, but only give the right to buy or sell the underlying commodity rather than the obligation. For example, a farmer will sell options on his cattle if he thinks prices are going to drop before he takes them to market; conversely, a meat processing company will buy futures on cattle if they believe that prices will rise. Both are non-traders but they have interests in the commodity. The final part of the equation is the investor who attempts to make a profit by successfully trading these commodities.
Futures or Cash Settlement
Futures options are settled in either cash or a futures contract in the underlying security when they are exercised. In-the-money, cash-settled futures options are valued using the trading price of the underlying security at expiration, and the profit is placed into the trader's account. In-the-money, futures settled options are converted into the appropriate futures contract, which the trader can then buy or sell to realize the profit or hold the purchase and simply continue commodity trading.
Because futures options contracts only give the holder the right to purchase, successful traders donít have to purchase losing positions. If an investor is holding a position that has not prospered according to the contract, he or she can just walk away from the agreement and let it expire. This is the benefit of futures options over standard futures contracts; the ability to walk away from a losing position leaves the investor with a reduced exposure. Conversely, an investor that is holding a contract when the buyer does not exercise his or her position has profited by receiving the premium for selling that position. Such a strategy is helpful during negative periods in the market because it allows for profit taking in a less risky manner.
Futures options, although they are quite similar to standard futures contracts, still possess features that make them very desirable for successful trading. This type of trading can open new markets for investors looking to make money.