When it comes to trading futures, there are two types of contracts that traders can use to manage their risk and gain exposure to the underlying asset. The first type is a futures contract, which obligates the buyer to purchase the underlying asset at a predetermined price on a specific date, and the seller to deliver the asset at that price. The second type is an option on a futures contract, which gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a specific price before a certain date. In this article, we`ll discuss what an option on a futures contract is and how it works.
What is an option on a futures contract?
An option on a futures contract is a financial instrument that gives the buyer the right, but not the obligation, to buy or sell a futures contract at a predetermined price on or before a specific date. The price at which the option can be exercised is called the strike price, while the specific date by which the option needs to be exercised is called the expiration date.
There are two types of options on futures contracts: call options and put options. A call option gives the buyer the right to buy a futures contract at the strike price, while a put option gives the buyer the right to sell a futures contract at the strike price. The buyer of an option pays a premium to the seller, who is also referred to as the writer of the option. The premium is the price the buyer pays for the right to exercise the option.
How does an option on a futures contract work?
Let`s say that a trader expects the price of crude oil to rise over the next few months. Rather than buying a crude oil futures contract outright, the trader could buy a call option on a crude oil futures contract. If the price of crude oil rises above the strike price of the call option before the expiration date, the trader can exercise the option and buy the futures contract at the strike price. If the price of crude oil does not rise above the strike price by the expiration date, the trader can simply let the option expire and lose only the premium paid.
On the other hand, if the trader expects the price of crude oil to fall, they could buy a put option on a crude oil futures contract. If the price of crude oil falls below the strike price of the put option before the expiration date, the trader can exercise the option and sell the futures contract at the strike price. If the price of crude oil does not fall below the strike price by the expiration date, the trader can let the option expire and only lose the premium paid.
Conclusion
An option on a futures contract is a versatile financial instrument that can be used to manage risk and gain exposure to the underlying asset. By buying a call option on a futures contract, a trader can profit from an increase in the price of the underlying asset, while buying a put option can profit from a decrease in the price of the underlying asset. As with any financial instrument, it`s important to understand the risks involved and to do your research before trading options on futures contracts.