Editor's note: In this week’s Swim LessonsSM column, Scott Connor introduces the basics of futures options. For more on this topic, TD Ameritrade clients can join Swim LessonsSM in the thinkorswim platform® on Wednesday June 28th at 10:30 AM CT for a live educational show on "An Intro to Futures Options".
While a good chunk of our Swim Lessons episodes feature equity options—options on stocks and stock indexes—we also like to feature options on futures from time to time.
In fact, appropriately approved accounts at TD Ameritrade can trade options on a wide array of futures products on the thinkorswim®platform—everything from grains like corn, soybeans and wheat, foreign currencies like euros, pounds and yen, Treasury products such as bonds, notes and Eurodollars, energy products like crude oil and natural gas, and precious metals. Stock indexes, too, like the S&P 500, Dow Jones Industrial Average and the Nasdaq 100, have their own futures contracts, and options are listed on those contracts as well.
And while options on futures share many of the same characteristics of their equity cousins, there are a few subtle differences that make them unique. But if you're an equity options trader looking to add new trading alternatives or exposure to different asset classes, read on and decide if options on futures might be right for you.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation. Futures and futures options trading is speculative and is not suitable for all investors.
With standard U.S. equity options, when you exercise or are assigned on a contract, the deliverable is 100 shares of stock. So if you exercise a call option, for example, you're exercising your right to buy 100 shares of the stock at the strike price, on or before the expiration date.
But futures, in contrast, are contracts for future delivery of the underlying commodity, financial product, etc. So when you exercise or are assigned an option, you're taking either a long or short position in the underlying futures contract. And each futures product has its own delivery and settlement cycle, and a list of option series that expire into each futures contract. For example, many financial futures, such as 10-year T-Note futures (/TY), are on the quarterly futures delivery cycle (March, June, September, December).
But each quarterly futures contract also has monthly, and usually weekly option expirations, so it's important to know which futures contract an option is based upon. July and August options, for example, will expire into the September future.
Crude oil, however, has a futures delivery each month. If you’re a TD Ameritrade client and you need a cheat sheet, refer to the calendar on the thinkorswim platform by going to MarketWatch > Calendar > and check the Futures Liquidation box. Also, futures and options exchanges list information on delivery and expiration dates, contract specifications, margin and performance bond requirements and more on their websites.
Again, equity option contracts represent 100 shares of the underlying stock. The multiplier is 100, so each penny the price of an equity option goes up or down will change the value of the contract by $1. For example, if you sold a call option for $1.50, and you bought it back for $3, you would have lost $150, plus transaction costs. If instead, the option expired out-of-the-money (OTM), you would have made $150, minus transaction costs.
Futures contracts—and thus the minimum price fluctuation ("tick") of futures and options prices— come in different sizes. Corn (/ZC) and soybean (/ZS) contracts, for example, are quoted in dollars and cents per bushel, and the contract size is 5000 bushels. A quarter-cent, the minimum price fluctuation ("tick size"), would be (5000 x $0.0025) = $12.50. Crude oil (/CL), quoted in dollars and cents per barrel, has a contract size of 1000 barrels, so a one-cent tick would be $10.
If you're an experienced equity options trader, you likely understand skew. In general, the implied volatility (IV) for an OTM put is higher than the IV of an OTM call, stemming from the perception that stocks fall faster than they rise, or that there's a greater likelihood of "panic" to the downside than the upside. In trader parlance, we would say the stock market can "take the stairs up but the elevator down.
It's the same basic premise behind the CBOE Volatility Index (VIX), which is known as the "fear gauge," as it tends to rise as the market falls and vice versa.
But options on futures can behave, and thus be priced, quite differently. Options of foodstuffs, like grains, oilseeds, livestock and such, might have a natural upside skew, with OTM calls having a higher IV than OTM puts. Which makes sense, right? Food scarcity can lead to frenzied buying.
Other contracts, such as some foreign currencies, have no "natural" skew, and skew can vary depending on market conditions, expectations, and the supply and demand of upside versus downside options.
The same basic math applies to both equity options and options on futures. Option prices are calculated using the same basic inputs—price of the underlying, days until expiration, prevailing interest rates, implied volatility—and the expiration payout graphs look the same. And the risk assessments and sensitivities—those "greeks" such as delta, gamma, theta and vega, are the same.
Differences aside, options on futures can be another way for experienced traders to pursue their objectives, in the same fashion as equities. From single-leg strategies to multi-leg strategies such as vertical spreads, straddles, strangles, iron condors and more, we'll feature them all in our daily Swim Lessons broadcasts.
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