Futures options can be a low-risk way to approach the futures markets. Many new traders start by trading futures options instead of straight futures contracts. There is less risk and volatility whenbuying options compared with futures contracts. Many professional traders only trade options. Before you can trade futures options, it is important to understand the basics.
Futures Options
An option is the right, not the obligation, to buy or sell a futures contract at a designated strike price for a particular time. Buying options allows a trader to speculate on changes in the price of a futures contract. This is accomplished by purchasing call or put options.
The purchase of a call option is a long position, a bet that the underlying futures price will move higher. For example, if one expects corn futures to move higher, they might buy a corn call option. The purchase of a put option is a short position, a bet that the underlying futures price will move lower. For example, if one expects soybean futures to move lower, they might buy a soybean put option.
Key Terms
Premium: The price the buyer pays and seller receives for an option is the premium. Options are price insurance. The lower the odds of an option moving to the strike price, the less expensive on an absolute basis and the higher the odds of an option moving to the strike price, the more expensive these derivative instruments become.
Contract Months (Time): All options have an expiration date;they only are valid for a particular time. Options are wasting assets; they do not last forever.For example, a December corn call expires in late November. As assets with a limited time horizon, attention must be accorded to option positions. The longer the duration of an option, the more expensive it will be. The term portion of an option's premium is its time value.
Strike Price: This is the price at which you could buy or sell the underlying futures contract. The strike price is theinsurance price. Think of it this way: The difference between a current market price and the strike price is similar to the deductible in other forms of insurance. As an example, a December $3.50 corn call allows you to buy a December futures contract at $3.50 anytime before the option expires. Most traders do not convert options to futures positions; they close the option position before expiration.
Buying an Option
If one expects the price of gold futures to move higher over the next 3 to 6 months, they would likelypurchase a call option.
Purchase, 1 December $1,400 gold call at $15:
- 1: Number of option contracts bought (represents 1 gold futures contract of 100 ounces)
- December: Month of option contract
- $1,400: Strike price
- Gold: Underlying futures contract
- Call: Type of option
- $15: Premium ($1,500 is the price to buy this option or, 100 ounces of gold x $15 = $1,500)
Buying an option is the equivalent of buying insurance that the price of an asset will appreciate. Buying a put option is the equivalent of buying insurance that the price of an asset will depreciate. Buyers of options are purchasers of insurance.
When you buy an option, the risk is limited to the premium that you pay. Selling an option is the equivalent of acting as the insurance company. When you sell an option, all you can earn is the premium that you initially receive. The potential for losses is unlimited. The best hedge for an option is another option on the same asset as options act similarly over time.
The Importance of Volatility
The chief determinate of option premiums is “implied volatility,” or the market’s perception of the future variance of the underlying asset. Historical volatility, on the other hand, is the actual historical variance of the underlying asset in the past.
Frequently Asked Questions (FAQs)
How do you trade futures options?
To trade futures or options on futures, you'll need access to the futures market through a brokerage account. Not all stockbrokers offer access to the futures market, so you'll need to ensure that you open an account with a company that will meet your needs. Futures accounts may also have higher barriers to access, such as higher capital requirements.
What are equity futures?
"Equity futures" refer to futures that track stock indexes. For example, "ES" futures contracts track the S&P 500. "YM" contracts track the Dow Jones Industrial Average. Aside from equity indexes, traders can also use futures contracts to speculate on interest rates, commodities, currencies, and even weather events.
How do you hedge futures positions with options?
Hedging is a strategy that involves taking a small position counter to a larger position that you hold. The idea is that you use the small position to protect your larger position. Either your small position profits—offsetting some of the loss in your larger position—or your small position loses value while your larger position continues to profit.
Options work well for this purpose, because they allow you to express specific opinions about where the price will go and how quickly it will go there. For example, if you own ES contracts that will expire in six months, but you think ES will lose value over the next month, you can buy a put or sell a call to provide some downside protection without touching your initial ES position.
FAQs
Trade futures with strict stop losses. This is a very basic norm in any trading activity but this will ensure that you are out of losing positions fast. Is it possible that after I trigger the stop loss the stock may eventually hit my target? That is perfectly possible.
How to reduce risk in futures trading? ›
Risk management is critical to successful futures trading. It involves a comprehensive approach that includes assessing risk tolerance, setting clear trading goals, choosing appropriate sizes for your positions, utilizing stop-loss orders, and diversifying your positions.
Is futures trading more risky? ›
That said, generally speaking, futures trading is often considered riskier than stock trading because of the high leverage and volatility involved that can expose traders to significant price moves.
Are futures less risky than forwards? ›
There is less oversight for forward contracts as privately negotiated, while futures are regulated by the Commodity Futures Trading Commission (CFTC). Forwards have more counterparty risk than futures.
What is the least risky option trading strategy? ›
Some low risk options strategies that we could recommend are selling a put spread, selling a call spread, and relying on a collar strategy. Compared to mere options selling, the collar strategy can further protect against downside risk.
What is the biggest risk of loss in futures trading? ›
One of the simplest and commonest risks of futures trading is the price risk. For example, if you buy futures, you expect the price to go up. However, if the price goes down, you are at risk of loss. For futures traders, the biggest risks of futures trading come from the adverse movement of prices.
What are the 5 ways to reduce risk? ›
Five common strategies for managing risk are avoidance, retention, transferring, sharing, and loss reduction. Each technique aims to address and reduce risk while understanding that risk is impossible to eliminate completely.
What is the best platform to trade futures? ›
Best Futures Trading Platforms of 2024
- Best for Professional Futures Traders: Interactive Brokers.
- Best for Dedicated Futures Traders: NinjaTrader.
- Best for Futures Education: E*TRADE.
- Best for Desktop Futures Trading: TradeStation.
1:00 – 3:00 PM is the most liquid part of the afternoon as professional traders balance their books into the close, the last 20 minutes or so into 3:00 PM, the highest volume.
Why do people prefer options over futures? ›
The choice between futures and options depends on your investment goals and risk tolerance – Both instruments can be used for hedging, but options offer more flexibility and limited risk. Futures offer higher potential profits but also higher risk, while options provide limited profit potential with capped losses.
Cons
- Costs: Trading options on futures can involve several types of costs, including commissions, bid-ask spreads, and, for options buyers, the premium.
- Risk of Illiquidity: Some options on futures may be illiquid, meaning they are not traded frequently.
Common risks of F&O trading include: F&O orders can be executed partially or with significant price differences due to liquidity and market volatility. Due to a large difference in the buying and the selling price, orders can be executed at prices far from the Last Traded Price (LTP), increasing impact costs.
How to trade futures for beginners? ›
How to trade futures
- Understand how futures trading works.
- Pick a futures market to trade.
- Create an account and log in.
- Decide whether to go long or short.
- Place your first trade.
- Set your stops and limits.
- Monitor and close your position.
On-screen text: Disclosure: Futures trading involves substantial risk and is not suitable for all investors, and you can experience a significant loss of funds, or you may lose more than the funds you invested.
Are futures harder than stocks? ›
It's easy to get started with your futures trading account! Futures trading generally has a lower initial account opening capital requirement than stock trading. With stocks, there are day trading rules that require a trader to maintain minimum account balance of $25,000 which can be a high bar for new traders.
What are the easiest futures to trade? ›
High Liquidity For Low Slippage
- Eurodollar (GE)
- E-mini S&P 500 (ES)
- 10-Year Treasury Note (ZN)
- 5-Year Treasury Note (ZF)
- Crude Oil WTI (CL)
- Natural Gas (NG)
- U.S. Treasury Bond (ZB)
- E-mini Nasdaq 100 (NQ)
Minimum Account Size
A pattern day trader who executes four or more round turns in a single security within a week is required to maintain a minimum equity of $25,000 in their brokerage account. But a futures trader is not required to meet this minimum account size.
What is the minimum needed to trade futures? ›
To apply for futures trading approval, your account must have: Margin approval (check your margin approval) An account minimum of $1,500 (required for margin accounts.) A minimum net liquidation value (NLV) of $25,000 to trade futures in an IRA.
What is risk free rate in futures? ›
The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. The so-called "real" risk-free rate can be calculated by subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.
