While both futures and options are popular derivative instruments in and of themselves, the term ‘future options’ can be confusing for many. Let us unpack this for you and explain the real meaning.
We will also give you future and option tips and examples for a realistic overview.
Future option meaning
This type of option is a right to buy or sell a futures contract at a prefixed price on a set date. A future option trading contract (also called option on futures) awards the buyer or seller of the option the right to buy or sell the underlying futures contract at a pre-determined price on the day the contract expires. In India, the expiration date of all options is the last Thursday of every month.
The primary difference between an option and a futures contract is while an option is a right to buy or sell an underlying asset at pre-decided prices, a futures contract is an obligation on the part of buyers and sellers to execute the trade at pre-decided prices on the date mutually agreed. Similarly, an option on futures also remains a right that can be claimed by the buyer or seller to execute a sale or buy trade of a futures contract on the expiration date.
A future option trading contract is a unique product because it is a derivative of a derivative. A derivative is called so because it gets its value from the value of the underlying asset. Here, in this case, the option (a derivative) gets its value from the underlying derivative which is a futures contract, which, further, is a derivative of its underlying assets like commodity, bonds, indices or equity shares. So a futures option could be a call or put option contract on commodity futures, stock futures or interest rate futures or futures of any other underlying asset. Let’s look the types and instances of trading.
Different types of future options
- Options on index futures
Option contract on index futures is the right to buy or sell a particular index future, say S&P CNX NIFTY at a mutually agreed-upon price on a fixed date, which is the date on which the option contract expires.
- Options on currency futures
Options on currency futuresare the rights to trade currency futures at prefixed prices on the contract’s expiration day. Indian bourses like NSE allow futures trading in 4 currencies US Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY).
For example, a buyer could purchase an option to buy a one month USD futures contract at Rs. 65/$.
- Future Options in share market
Similarly, future options in share market or options on stock futures are a buyer’s or seller’s right to purchase (also called a < ahref="https://www.angelbroking.com/futures-and-options/call-options"> call option) or sell off (also called a put option) a stock futures contract at mutually determined prices on the date the tenor of contract ends.
A stock future is a binding contract between the buyer and seller to execute the buy or sell trade of the stock shares at pre-determined prices on a specific date.
- Options on interest rate futures
Options on interest rate futures are a contract that provides the buyer and seller right that they can claim to trade off interest rate futures at prices mutually agreed upon between the two parties on a specific date.
Interest Rate Futures are obligations to buy or sell debt products at a mutually fixed price, also called the strike price, on a specific future date. For interest-rate futures, the underlying assets are government bonds or T-bills.
What is the call future option?
This is a future option trading contract where buyers have a right to buy either a currency, commodity or stock futures, at a mutually agreed-upon price or strike price on the date of options expiry. With call options, the buyer is said to be in a long position, that is, he will look to exercise his right to buy the underlying asset if the strike price is lower than the prevailing price in the futures market. In purchasing a call option, he buys this right that he may or may not exercise on the expiration date by paying a premium.
How does a call future option work?
Let us see how a call future option works with the index future as an underlying asset.
In a hypothetical example, suppose trader C is bullish and expects the price of NIFTY index futures to rise to Rs. 13,000 or higher in the nearing months. He buys a one-month index future option contract at a strike price of Rs. 12,200, where the spot price of the index future is Rs.11,950. The difference of Rs.250 is the premium charged for the contract.
Now one month later on the day the contract expires, if the NIFTY index future trades at anywhere above Rs.12,200, (probably Rs.13,300), then trader C will be said to be In The Money. Trader C can exercise his right to buy the NIFTY index future contract at Rs.12,200, making an apparent gain of Rs.1100 due to the difference between the strike price and spot price of the index future.
Hedging bets can sometimes go wrong. Now, in another scenario, if the index future trades anywhere less than Rs. 12,200 or lower than the strike price, at say Rs.11,000, then trader C stands to make a notional loss of Rs.1200. He is said to be out of money in the call option if the strike price is higher than the prevailing prices of the index future on the day the option contract expires. In that case, trader C can buy future contracts from the spot market instead of exercising his buying right.
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 at a pre-determined price on the date of options expiration. With put options, the owner of the option would be in a short position, that is, he will look to sell the underlying future contract at a strike price higher than current prices of the futures contract.
How does a put future option work?
Let us see how a put future option works with index futures as an underlying asset.
What makes the derivative market interestingly volatile is that there are bullish and bearish investors. Where people are expecting the prices of an underlying asset to fall, there will be others who would expect the prices to go up.
Suppose trader D, unlike trader C, is bearish and expects the price of NIFTY index futures to fall to Rs. 9,000 from the spot price of Rs.11,950. He enters a one month put future option contract giving him the right to sell the index futures at a strike price of say Rs. 11,000 one month later when the contract expires.
Going by the principle of buy low and sell high, now one month later on the day the contract expires, if the NIFTY index future trades at anywhere above the strike price of Rs.11,000, at say Rs.12,000, then trader D will not want to exercise his right to sell the index futures because the spot price is higher than the strike price. Trader D will be said to be Out of The Money in that case.
In another scenario, if the NIFTY index futures is currently at say Rs.10,000 or anywhere lower than the strike price of Rs.11,000, trader D will exercise his right to sell the index futures at the strike price, pocketing a gain of Rs. 1000. In that case, trader D’s put option will be said to be In the Money when the strike price is higher than the spot price of the underlying asset.