Why Traders Use Options on Futures Contracts

Why Traders Use Options on Futures Contracts

Meaning Of Future Option

This option gives you the right to purchase or sell a futures contract at a certain price on a specific date. A future option trading contract (also known as a futures option) grants the buyer or seller of the option the right to buy or sell the underlying futures contract at a predetermined price on the contract's expiration date. In India, all options expire on the final Thursday of every month.

The primary distinction between an option and a futures contract is that an option is a right to buy or sell an underlying asset at predetermined prices, whereas a futures contract is an obligation on the part of buyers and sellers to execute the trade at predetermined prices on the mutually agreed-upon date. Similarly, a futures option is a right that a buyer or seller might exercise to execute a sale or buy trade of a futures contract on the expiration date. Because it is a derivative of a derivative, a future option trading contract is a one-of-a-kind product. A derivative is so named because its value is determined by the underlying asset's value. In this example, the option (a derivative) derives its value from the underlying derivative, which is a futures contract, which is, in turn, a derivative of its underlying assets, such as bonds, commodities, indices, or equity shares. A futures option could be a call or put option contract on stock futures, commodity futures, interest rate futures, or any other underlying asset futures.

Different Types Of Future Options 

  • Options On Currency Futures - Currency futures options are the rights to trade currency futures at predetermined prices on the contract's expiration date. Futures online trading in four currencies is permitted on Indian exchanges, including the EUR, USD, GBP, and JPY.
  • Options on index futures - An option contract on index futures is the right to buy or sell a certain index future at a mutually agreed-upon price on a defined date, which is the expiration date of the option contract.
  • Options on interest rate futures - They are a contract that gives the buyer and seller the right to trade off interest rate futures at mutually agreed-upon prices on a certain date. Interest Rate Futures are contracts to acquire or sell debt goods on a specified future date at a mutually agreed-upon price, commonly known as the strike price. The underlying assets for interest-rate futures are government bonds.
  • Future Options in share market - Similarly, future options in the stock market or options on stock futures are a buyer's or seller's right to purchase or sell off a stock futures contract at mutually established prices on the contract's expiration date. A stock future is a legally binding contract between the buyer and seller to buy or sell stock shares at predetermined prices on a particular date.

 

What Exactly Is The Call Future Option?

This is a future option trading contract in which purchasers have the right to buy either commodity, currency or stock futures at a mutually agreed-upon price or strike price on the expiry date of the options. The buyer of call options is considered to be in a long position, which means that he will try to exercise his right to buy the underlying asset if the strike price is lower than the current price in the futures market. He buys this right by acquiring a call option, which he may or may not exercise on the expiration date by paying a premium.

Let's have a look at how a call future option works with an index future as the underlying asset. Assume trader C is bullish and believes the price of NIFTY index futures will grow to Rs 13,000 or higher in the next months. He purchases a one-month index future option contract with a strike price of Rs 12,200, where the index future's market price is Rs 11,950. The difference of Rs 250 is the contract premium.

Now, one month later, on the contract's expiration date, if the NIFTY index futures trades at or above Rs 12,200, trader C is considered to be in the money. Trader C can exercise his entitlement to acquire the NIFTY index future contract at Rs 12,200, netting a Rs 1100 profit due to the difference between the strike and spot price of the index future.

Hedging bets can occasionally backfire. In another example, if the index futures trade for less than Rs 12,200 or less than the strike price, say Rs 11,000, trader C will incur a notional loss of Rs 1200. If the strike price of the call option is higher than the current values of the index futures on the day the option contract expires, he is said to be out of money. In that situation, instead of exercising his buying right, trader C can buy future contracts on the spot market.

What Is A Put Option On The Futures?

A put future option trading contract is the right to sell a futures contract as an underlying asset on the expiration date of the options. The owner of a put option would be in a short position, looking to sell the underlying future contract at a strike price higher than the current price of the futures contract.

Let's look at how a put future option works when index futures are used as the underlying asset. The fact that there are bullish and bearish investors makes the derivative market interestingly dynamic. Whereas some anticipate that the price of an underlying asset will fall, others anticipate that the price will rise.

Assume trader D, in contrast to trader C, is negative and anticipates the NIFTY index futures price to fall to Rs 9,000 from the current spot price of Rs 11,950. He joins a one-month put future option contract that gives him the opportunity to sell the index futures at a strike price of say Rs 11,000 when the contract expires one month later.

Following the principle of buy low and sell high, if the NIFTY index futures trades at any price over the strike price of Rs 11,000, say Rs 12,000, then trader D will not wish to exercise his right to sell the index futures because the spot price is greater than the strike price. In that circumstance, Trader D is considered to be out of the money.

In another instance, if the NIFTY index futures are now trading at Rs 10,000 or lower than the strike price of Rs 11,000, trader D will sell the index futures at the strike price, pocketing a Rs 1000 profit. In that situation, trader D's put option is said to be In the Money when the strike price is greater than the underlying asset's spot price.

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