A Beginner’s Guide to Futures Options Trading: Key Concepts and Strategies
You know about futures. You know about options. But what about futures options? Learn the key concepts and strategies for futures options trading.
You can purchase futures contracts on various financial products, from equity indexes to commodities. Trading options on futures involves writing or buying a call or put option depending on how you think those underlying assets will move.
Buying options on futures is one way to invest in the movement of futures contracts without purchasing the actual future.
Sound confusing? Don’t worry; by the end of this article, you’ll go from a futures option trading beginner to understanding the concepts and strategies of this investment technique.
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What to Know Before Trading Futures Options
If you want to trade futures options, you must understand:
- How to trade options
- How to trade futures
- How to trade futures options
- The details of contracts that you want to trade
- What drives options and futures prices
- How to determine which contracts to buy and sell
We’ll briefly explain put and call options below, but if you don’t understand those two concepts, we suggest learning more before jumping into trading futures options.
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What Is Futures Options Trading?
Futures options are a security that grants you the right to buy and sell a futures contract at a set price and specific date (strike price and expiration date). There are two kinds of futures options: put options and call options.
Put options give you the right to sell a futures contract, and call options give you the right to buy a futures contract.
So, if you think the market will rise, you’ll look at buying call options. But if you think the market will fall, you’ll consider buying put options. Most futures contracts offer futures options, each with unique specifications, making the entire process more complex than trading stock options or futures contracts.
More specifically, futures options often have different expiration dates that occur before the expiration date of their underlying futures contract. This date is typically the end of the month before the underlying contract’s delivery month. For example, an April option would expire in March.
However, each futures option contract has the same contract value as its underlying future because it represents how much of the commodity is to be traded. Every futures contract requires investors to put up a deposit (margin), so that they have money set aside in case of a loss.
You trade futures options in contracts, each representing one contract of the underlying asset. In addition, multiple futures options contracts can relate or deliver into the same underlying futures contract.
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Why Consider Futures Options Trading?
Futures options trading brings benefits of both futures and options trading. These advantages include:
- Mitigated risk: Buying futures options limits your maximum risk — you can’t lose more than the premium you paid to purchase the option. However, there is no limit on potential profit.
- Liquid markets: Most futures markets trade six days a week and nearly 24 hours per day. There are a large number of people who trade actively, resulting in transparent pricing and tight bid-ask spread.
- Leverage: It takes less capital to purchase futures options than it does to trade futures directly. However, while there’s the possibility of greater profits with less capital, there is also an increased risk of substantial losses.
- Tax benefits: Compared to short-term stock traders, futures option traders gain an advantage when it comes to taxes. 60% of futures options count towards long-term capital gains and 40% count toward short-term capital gains.
- Market exposure: If you wanted exposure to oil through stock options, there would be numerous challenges — oil refining stocks are diversified far beyond crude oil. On the other hand, one crude oil futures option controls a future containing 1,000 barrels of crude oil.
Futures Options Trading Strategies to Improve Your Knowledge
You can use options on futures in various ways, depending on your risk tolerance, market expectations, and overall investing goals.
- Hedging: You can use futures options to hedge other risks. For example, let’s say a farmer grows primarily wheat but is worried about prices falling before harvest. In that case, he could buy a put option on wheat, offsetting the decrease in his crop’s value.
- Directional speculation: Another strategy for futures options trading is by speculating on the underlying asset’s price — will it rise or fall? If you believe a commodity will rise in price, you would buy a call option on its futures. On the other hand, if you believe the commodity’s price will fall, you would buy a put option on the futures.
- Neutral speculation: If expectations for price volatility are high, options premiums usually rise. In these situations, traders believing that the underlying asset’s price will remain relatively stable would sell options, making their profit from the premiums. However, this is a risky strategy; if the price does move significantly, you could face massive losses.
- Spreads: The final strategy we want to discuss is creating spread positions using futures options; however, this is a more sophisticated process. Spreads involve purchasing and selling options on the same asset. Experienced traders can use spreads to profit from price differences and take advantage of expected changes in volatility.
Using Futures Options to Manage Risk and Diversify Investments
For many traders, finding new ways to manage risk in their portfolios is a top priority. As you’ve learned today, futures options can provide opportunities to mitigate risks and further diversify your portfolio.
Whether your goal is to hedge against your portfolio risks, reduce your trading cost base, or complement trades you make in equity markets, futures options trading comes with distinct advantages.
While trading futures options is complex and can result in significant losses, it can also be a fantastic way for investors to manage risk when buying options and offers a high level of flexibility.
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