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Derivatives With a Twist: Options on Futures vs. Equity Options

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December 7, 2017
Twist of lime: Options on futures vs. equity options
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Tax audit. Crash. Emergency liquidation. Let's face it—some financial terms are scary, perhaps for good reason. But here's a term that may sound scarier than it is: derivatives.

A derivative product is simply something that derives its price from the price of something else. For example, stock options—a put you might buy for protection on a stock you own, or the covered call you might write—those are derivatives. The option premium is "derived" in part from the price of the underlying stock.

Futures contracts are derivatives, as well. Futures prices are derived from the spot, or cash price, of the underlying. And an option on a futures contract? Is that a derivative on a derivative? Yep, and this derivative shares many characteristics with its equity option cousin.

Wide Array of Options on Futures

If you have an approved account at TD Ameritrade, you can trade options on a number of futures products on the thinkorswim® platform:

  • Stock indexes such as the S&P 500 and NASDAQ 100
  • Grains like corn, soybeans, and wheat
  • Foreign currencies like the euro and British pound
  • Treasury products such as 30-year Bond and 10-year Note 
  • Energy products like crude oil and natural gas
  • Precious metals such as gold

And although options on futures share many of the same characteristics of their equity cousins, there are a few subtle differences that make them unique. 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.

Same Old Same Old …

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, implied volatility (IV), days until expiration, prevailing interest rates. Plus, the risk profile graphs look the same. And those "greeks"—delta, gamma, theta and vega—are the same as well.

From basic call and put option strategies to multi-leg strategies such as straddles and strangles, vertical spreads, iron condors, and more, if you're an experienced trader, options on futures can be another way to pursue your objectives, in the same fashion as equity options.

... But There Are a Few Differences

The deliverable. 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. 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 E-mini S&P 500 futures (/ES), are on the quarterly futures delivery cycle (March, June, September, December).

And within each quarterly futures contract there are often monthly and weekly option expirations, so it's important to know which futures contract an option is based on. July and August options, for example, will typically expire into the September future. Crude oil, in contrast, has a futures delivery each month.

Need a cheat sheet? If you’re a TD Ameritrade client, you can refer to the calendar on the thinkorswim platform by going to MarketWatch > Calendar and checking 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.

Contract size, multipliers, and tick sizes. Standard equity option contracts represent 100 shares of the underlying stock. The multiplier is 100, so each penny that 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, and you bought it back for $1.50, you would have lost $50, plus transaction costs. If, instead, the option expired out of the money (OTM), you would have made $100, minus transaction costs.

Futures contracts, and the options based on them, come in all shapes and sizes. Some are cash settled; some are physically settled. Some have contract sizes that are nice round numbers, and quoted in dollars and cents; some are quoted in fractions. Although there are many different multipliers in the futures world, they’re based on contract size, and it’s the contract sizes that tend to differ. For more on options contract terms, please refer to this primer.

Futures and options on futures

FIGURE 1: FUTURES AND OPTIONS ON FUTURES.

In the thinkorswim® platform from TD Ameritrade, under the Trade tab, click the dropdown box, then the Futures tab to see the available products and some contract terms. For illustrative purposes only.

Perhaps a different skew. If you're an experienced equity options trader, you've likely noticed that, typically, the 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. It's the same basic premise behind the CBOE Volatility Index (VIX), aka the "fear gauge," which tends to rise as the market falls and vice versa. See the /ES option chain in figure 2.

Downside skew in /ES

FIGURE 2: DOWNSIDE SKEW IN /ES.

Note the higher implied vol in downside strikes in the E-mini S&P 500 (/ES). Data source: CME Group. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only.

But options on some futures can behave, and thus be priced, quite differently. Options on corn and soybean futures, for example, might have a natural upside skew, with OTM calls having a higher IV than OTM puts. Which stands to reason, as food scarcity could potentially lead to frenzied buying. See the option chain for soybean futures (/ZS) in figure 3.

Upside skew in /ZS

FIGURE 3: UPSIDE SKEW IN /ZS.

Note the higher implied vol in upside strikes in options on soybean futures (/ZS). Data source: CME Group. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only.

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.

Margin requirements. One final difference between equity options and options on futures is margin—the deposit required by your broker on an open position. Unlike equity options, which use Reg T margin, options on futures use SPAN margin, a risk-based margin model that essentially stress-tests your options and futures positions against a variety of potential price and volatility scenarios to determine an appropriate margin amount.

So there you have it. If you’re an equity options trader looking to “up your game” to a new line of derivatives, or an investor looking for exposure in additional asset classes, you might consider options on futures. Just keep the twists in mind.

Options on Futures vs. Equity and Index Options

Visit the thinkorswim® Learning Center for a full comparison—trading hours, margin, expiration, settlement, and risk profile graphs.   

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