Same Building Blocks, Different Products: Options on Futures Intro

If you’ve read any options-related content on The Ticker Tape, you’ve likely noticed that a lot of strategy examples feature equity options—options on stocks and stock indexes. However, many opportunities lie beyond the world of stocks and stock options, such as options on futures contracts.

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, to foreign currencies like euros, pounds, and yen, to Treasury products such as bonds, notes, and eurodollars, to energy products like crude oil and natural gas, as well as precious metals. Stock indexes like the S&P 500, Dow Jones Industrial Average, and the Nasdaq 100 have their own futures contracts, too, and options are listed on those contracts as well.

Stock options and options on futures can be thought of as cousins—a lot of shared DNA, but with some subtle differences thrown in. So 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.

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 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. 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 (see figure 1). Also, futures and options exchanges list information on delivery and expiration dates, contract specifications, margin and performance bond requirements, and more on their websites.

Know the Contract Size—and Thus the Tick Size

Again, standard 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 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 5,000 bushels. A quarter-cent, the minimum price fluctuation (“tick size”), would be (5,000 x $0.0025) = $12.50. Crude oil (/CL), quoted in dollars and cents per barrel, has a contract size of 1,000 barrels, so a one-cent tick would be $10. Before you trade, know the contract specs. 

Don’t Take the Skew for Granted

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.    

Same Basic—and Advanced—Strategies

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 a similar fashion as equities.