7/29/2019 Options on Futures Final Doc

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Introduction

Futures contracts have been traded on U.S. exchanges since 1865, options on futures

contracts were not introduced until 1982. Initially offe red as part of a government pilot

program, their success eventually led to widespread use of options on agricultural as well asfinancial futures contracts.

Options on futures contracts can offer a wide and diverse range of potentially attractive in-

vestment opportunities. However, options trading is a speculative investment and should be

treated as such. Even though the purchase of options on futures contracts involves a limited

risk (losses are limited to the costs of purchasing the option), it is nonetheless possible to lose

your entire investment in a short period of time. And for investors w ho sell rather than buy

options, there is no limit at all to the size of potential losses.

Defination

Options on Futures are also known as Futures Options, are an unique form of derivative

instrument as it is a Derivative on Derivative. Options on Futures a re options that derive

their value from another derivative instrument, Futures, which in turn derive their value from

an underlying asset such as an index or commodity.

Essentially, the futures specified in the option contract allows someone to enter into the

specified futures contract when the option expires.

Terminology

Strike Price :Also known as the exercise price, this is the stated price at which the buyer

of a call has the right to purchase a specific futures contract or at which the buyer of a put has

the right to sell a specific futures contract.

Underlying Contract : This is the specific futures contract that the option conveys the right

to buy (in the case of a call) or sell (in the case of a put).

Option Buyer : The option buyer is the person w ho acquires the rights conveyed by the

option: the right to purchase the underlying futures contract if the option is a call or the right

to sell the underlying futures contract if the option is a put.

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Option Seller ( Writer) : The option seller (also know n as the option writer or option

grantor) is the party that conveys the option rights to the option buyer.

Option price/premium: It is the price which the option buyer pays to the option seller. It is

also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the expiration date,

the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or the

exercise price.

American options: These can be exercised at any time upto the expiration date.

European options: These can be exercised only on the expiration date itself. European

options are easier to analyze than American options and properties of an American option are

frequently deduced from those of its European counterpart.

In-the-money option: An in-the-money (ITM) option would lead to a positive cash flow to

the holder if it were exercised immediately. A call option on the index is said to be in-the-

money when the current index stands at a level higher than the strike price

(i.e. spot price > strike price). If the index is much higher than the strike price, the call is said

to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option: An at-the-money (ATM) option would lead to zero cash flow if it

were exercised immediately. An option on the index is at-the-money when the cur- rent index

equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option would lead to a nega- tive

cash flow if it were exercised immediately. A call option on the index is out-of-the- money

when the current index stands at a level which is less than the strike price (i.e. spot price