Trading Options on Futures Contracts

The volatile financial markets provide excellent opportunities to take advantage of price movements. Typically, futures and options (F&O) are called derivatives as they derive value from the underlying assets. The derivatives market offers a unique way of building wealth using speculations on the future direction of stocks, commodities, currencies, and more. It allows you to capitalise on all types of markets – bullish, bearish, and neutral. 

Trading futures options allows you to create options contracts with futures as the underlying asset. It is a derivative of derivatives because a futures contract is already a derivative. In this blog, let's explore the key strategies to navigate this sophisticated market. 

Understanding the Difference Between Futures and Options

A quick overview of futures and options in the derivative market is given below:

• Futures Contracts – A futures contract is a legally binding agreement. You agree to buy or sell an underlying asset at a predetermined price on a specific future date. On the specified future date, the buyer must buy, and the seller must sell based on contract agreements. 
• Options – The options contract gives the right to the holder without the obligation to buy or sell an underlying asset at a specified strike price within a specific timeframe, which is the expiration date. This is not binding. So, you can choose not to honour the contract, and the option expires worthless. 

What is Trading Options on Futures Contracts?

Options on futures contracts is an options contract, where the underlying asset is a futures contract. Here, traders speculate on the future price of the futures contract without taking on the full commitment of a futures contract. Futures contracts come with two types of options:

1. Call Option – The holder has the right to buy a futures contract at the strike price before the option expiry
2. Put Option – The holder has the right to sell a futures contract at the specified price before the option expiry

Benefits of Trading Futures Options

Futures contracts require a large upfront investment with greater risk. The profits and losses are also amplified based on the price movement of the underlying asset. Some of the benefits of trading options on underlying futures are:

• Higher leverage – Options allow traders to control a larger futures position with a relatively smaller investment. It amplifies both profits and losses.
• Flexibility for profit generation – Different market strategies can be used to profit from all types of market conditions.
• Limited risk – For buyers of options, the maximum loss is limited to the premium paid for the option. This results in a defined and limited risk. 
• Hedging – Options on futures allow hedging against price movements in the underlying futures position. It provides insurance for investors against adverse market conditions. 

Example of Trading Options on Futures Contracts

For the same level of exposure, options on futures contracts provide more risk control with a cap on profit potential. Let's understand this difference with an example.

Consider the Nifty index (underlying asset for the futures contract) at 18,000 and a futures price of 18,100. Assume an option premium of Rs 100 and a lot size of 4, equating to 100 quantities. We will compare the outcomes of a futures contract versus a call option for Nifty futures. 

Futures Contract Details:

So, with Nifty futures, with a Rs 90,000 investment, you control Rs 18,00,000. If the price increase aligns with your speculation, you gain Rs 40,000; if the price falls against your speculation, you lose Rs 30,000. 

When you choose to trade options on Nifty futures, the scenario is explained below:

You buy a call option on Nifty futures with a strike price of 18,200 and a premium of Rs 100. 

Contract Details:

Choosing options for futures lets you get started with just Rs 7,500 for the same exposure to futures contracts. Your profit is Rs 22,500, and your loss is Rs 7,500 for the same scenario. 

As you can see, the profit for trading options on futures is lower than the futures contract itself. At the same time, the loss is limited to the premium. The futures contracts capture the full index movement. The potential profits are higher, and the risk is significantly more remarkable. Options on futures offer defined and controlled risks, making them an attractive method for managing exposure with a smaller investment. 

Common Futures Options Strategies

Some of the common strategies for trading futures options are:

• Covered Call – You hold a long position in a futures contract and sell a call option in the contract. It generates a premium income to enhance returns but limits upside potential if the market rallies significantly. 
• Protective Put - You hold a long position in a futures contract and buy a put option to protect against downside risk. It offers protection against falling prices. 
• Straddle and Strangle – In the straddle strategy, you buy both a call and a put option on the same futures contract with the same strike price and expiration date. Strangle involves buying out of the money call and put options. Both methods allow you to benefit from significant price movements in either direction. 
• Iron Condor – When there is low volatility with relative stability, you can combine selling out of the money call spread and out of the money put spread to benefit from the underlying market. While this limits the risk, it also caps potential gains. 

Conclusion

Trading futures options requires a sophisticated approach to risk management with opportunities to capitalise on market movements. It can enhance portfolio diversification with advanced tools for hedging and calculation. With options on futures, you can navigate the derivatives market with controlled risk and increased exposure due to the leverage. However, disciplined risk management and a deeper understanding of the financial instruments are crucial to growing wealth.