Options on Futures Contracts

An option on a future is the right, but not the obligation, to buy or sell a specified number of underlying futures contracts or a specified amount of a commodity, currency, index or financial instrument at an agreed upon price on or before a given future date. Options on futures are traded on the same exchanges that trade the underlying futures contracts and are standardized with respect to the quantity of the underlying futures contracts (by custom, one futures contract), expiration date, and exercise or strike price (the price at which the underlying futures contract can be bought or sold).

In the United States, standardized options on futures that are exercisable directly into securities and securities indexes are classified as securities subject to regulation by the Securities and Exchange Commission (SEC); these contracts are traded on U.S. securities exchanges. In contrast, futures and options on futures (including options on many stock index futures) are regulated by the Commodity Futures Trading Commission (CFTC) and traded on futures exchanges. The situation differs outside of the United States where, in many countries, there is a less distinct regulatory separation of the futures and securities industries and where, in many cases, financial futures are traded on stock exchanges.

There are two types of options on futures - call options and put options. A call option on a futures contract gives the buyer the right, but not the obligation, to purchase the underlying contract at a specified price (the strike or exercise price) during the life of the option. A futures put option gives the buyer the right, but not the obligation, to sell the underlying contract at the strike or exercise price before the option expires. The cost of obtaining this right to buy or sell is known as the option's "premium." This is the price that is bid and offered in the exchange pit or via the exchange's computerized trading system. As with futures, exchange-traded options on futures positions can be closed out by offset--execution of a trade of equal size on the other side of the market from the transaction that originated the position.

The major difference between futures and options on futures arises from the different obligations of an option's buyer and seller. A futures contract obligates both buyer and seller to perform the contract, either by an offsetting transaction or by delivery, and both parties to a futures contract derive a profit or loss equal to the difference between the price when the contract was initiated and when it was terminated. In contrast, an option buyer is not obliged to fulfill the option contract. The option buyer's loss is limited to the premium paid, but in order for the buyer to make a profit, the price must increase above (call option) or decrease below (put option) the option's strike price by the amount of the premium paid. In turn, the option seller (writer or grantor), in exchange for the premium received, must fulfill the option contract if the buyer so chooses. This situation--the option's exercise--takes place if the option has value (is "in the money") before it expires.