A futures option, or option on futures, is an option contract in which the underlying is a single futures contract. The buyer of a futures option contract has the right (but not the obligation) to assume a particular futures position at a specified price (the strike price) any time before the option expires. The futures option seller must assume the opposite futures position when the buyer exercises this right.
If you are unfamiliar with futures, it is recommended that you learn more about trading futures contracts before continuing with the rest of this article.
Things To Note When Trading Futures Options
Futures options usually expire near the end of the month that precedes the delivery month of the underlying futures contract (i.e. March option expires in February) and very often, it is on a Friday.
This is the price at which the futures position will be opened in the trading accounts of both the buyer and the seller if the futures option is exercised.
Exercise & Assignment
When a futures option is exercised, a futures position is opened at the predetermined strike price in both the buyer and the seller's account. Depending on whether a call or a put is exercised, the option buyer and seller will assume either a long position or a short position.
|Futures positions assumed upon option exercise|
|Buyer Assumes||Seller Assumes|
|Call Option||Long Futures Position||Short Futures Position|
|Put Option||Short Futures Position||Long Futures Position|
Futures Option Pricing
It is important to remember that the underlying of a futures options is the futures contract, not the commodity. Hence, the option price move along with the futures price and not the commodity price. Although the futures price tracks the commodity price closely, they are not the same. For highly leveraged products like options, the impact of such tiny differences can be greatly magnified.
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