Options on Futures
Option Basics
An option on a futures contract gives the buyer a right, not an obligation, to establish a futures position at the strike price. A call buyer gains from rising futures prices; a put buyer gains from falling prices. The buyer pays a nonrefundable premium. The writer receives the premium and is obligated to perform if assigned. Most U.S. options on futures are American-style, exercisable any business day before expiration.
Premium has intrinsic value and time value. For a call, intrinsic value is the greater of zero or futures price minus strike; for a put, it is the greater of zero or strike minus futures. In-the-money, at-the-money, and out-of-the-money describe the relationship between strike and futures price. Exercising a call creates a long futures position plus a cash settlement of intrinsic value; exercising a put creates a short futures position. Writers must post margin; buyers pay premium and have no margin obligation.
Traps
Buyers have rights; writers have obligations. An option is not a futures contract until exercised. Do not confuse an option’s premium with margin. A call writer faces potentially unlimited risk; a put writer’s risk is large but limited to the strike minus zero. European-style options can be exercised only at expiration.
Worked Example
A call has a strike of 400 and the futures price is 415. Intrinsic value = 415 − 400 = 15. If the premium is 18, time value = 18 − 15 = 3. If the futures price falls to 390, intrinsic value is zero and the buyer can lose the entire premium.