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Trading Options on Futures

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Previously in Know Your Options, we’ve discussed the differences between cash-settled options and stock-settled options.

Some readers have asked questions about trading options on commodities like oil, gold and agriculture products. In most cases, that will mean trading a another type of options – one that settles to futures.

The basic concept is no different than options that settle to stock or cash. The owner of the option still has the right, but not the obligation to buy (call) or sell (put) something at a certain price before a certain date, except the deliverable when an option is exercised is a futures contract.

For instance, if you are long a call with a strike price of $50 that expires in-the-money, you would purchase one futures contract on the underlying for $50. This is basically the same operation as the holder of a $50 strike call on a stock buying 100 shares of stock for $50/share at expiration.

In both cases, the trader still has a long position in the underlying after expiration.

Futures options are slightly more complicated than stock options for a few reasons.

The first is understanding which futures contract is deliverable for any given option. In most US markets, futures are not listed for all 12 months of the year, but options are. So that means multiple options expirations will share the same underlying contract.

For example, Corn futures at the Chicago Mercantile Exchange (CME - Free Report) expire in March, May, July, September and December, but there are options listed that expire each month. The options that expire in months when a futures contact does not trade are referred to as “serial” options. The underlying is the next futures expiration.

There are also options listed for which the underlying is a longer dated futures contract.

Practically, this means that as at trader, you’ll need to be aware what the underlying is for the options you’re trading, because it’s not as obvious as when you’re trading sock or cash settled options.

In some products – most notably equity index products, the underlying future expires at the same time as at least some of the options that are listed for it. This means those options are effectively cash-settled – the option expires to a future which immediately expires to cash.

The possibility of early exercise is also slightly different than it is for stock options. Because a futures contract costs nothing to carry, but options premiums must be paid at the time of purchase, deeply in the money futures options – both calls and puts – are likely to be exercised early to save the cost of carry on the option premium.

If you’re short a deep in-the-money option, don’t be surprised if you are assigned (the long side exercised the option) early and have a position in the futures rather than the short option. Because only options with a delta of 1.00 or very close are candidates for early exercise, the position you have will behave essentially the same, so the effect on you will be minimal.

So if you have a desire to speculate on the value of commodities, don’t be afraid to trade futures options. All of the fundamentals of entering and exiting a trade are the same. Just make sure you fully understand the specifications of the options you’re trading before you place the first order.

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