# Understanding Options on Futures: A Comprehensive Guide

## What Are Options on Futures?

An option on a [futures contract](https://www.investopedia.com/terms/f/futurescontract.asp) gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a strike price on or before the option's [expiration date](https://www.investopedia.com/terms/e/expirationdate.asp). These work similarly to stock options, but differ in that the underlying security is a futures contract and not the security that underlies the futures contract.

Most options on futures, including [index options](https://www.investopedia.com/terms/i/indexoption.asp), are [cash settled](https://www.investopedia.com/terms/c/cash-settled-options.asp) and [European-style](https://www.investopedia.com/terms/e/europeanoption.asp), which means that they can't be exercised early.

Understanding options on futures can be crucial for traders looking to expand leverage without using additional capital. This article article presents practical examples of options on futures that illustrate how these financial instruments function in real-world scenarios.

### Key Takeaways

*   Options on futures are derivatives that provide the right, but not the obligation, to buy or sell a futures contract at a predetermined price before expiration, offering flexibility in trading strategies.
*   Unlike stock options, options on futures often have European-style characteristics, meaning they can only be exercised at maturity, and are frequently cash settled, which simplifies the transaction process.
*   Trading options on futures allows investors to leverage positions more significantly compared to trading the futures contracts directly, as they require less upfront capital due to lower margin requirements.
*   The value and pricing of options on futures are influenced by multiple factors, including the expiration dates of both the option and futures contract and market forces such as supply and demand.
*   Despite offering higher leverage potential, options on futures come with the risk of losing the entire premium paid, emphasizing the importance of understanding all variables involved before engaging in these trades.

## Understanding the Functionality of Options on Futures

An option on a futures contract is very similar to a [stock option](https://www.investopedia.com/terms/s/stockoption.asp) in that it gives the buyer the right, but not obligation, to buy or sell the underlying asset, while creating a potential obligation for the seller of the option to buy or sell the underlying asset if the buyer so desires by [exercising](https://www.investopedia.com/terms/e/exercise.asp) that option. That means the option on a futures contract, or futures option, is a [derivative](https://www.investopedia.com/terms/d/derivative.asp) security of a derivative security. But the pricing and contract specifications of these options does not necessarily add leverage on top of leverage.

An [option](https://www.investopedia.com/terms/o/option.asp) on an S&P 500 futures contract, therefore, can be thought of as a second derivative of the S&P 500 index since the futures are themselves derivatives of the index. As such, there are more variables to consider as both the option and the futures contract have expiration dates and their own [supply and demand](https://www.investopedia.com/terms/l/law-of-supply-demand.asp) profiles. Time decay (also known as [theta](https://www.investopedia.com/terms/t/theta.asp)), works on options futures the same as options on other securities, so traders must account for this dynamic.

With call options on futures, the holder enters a long position to buy the [underlying asset](https://www.investopedia.com/terms/u/underlying-asset.asp) at the [strike price](https://www.investopedia.com/terms/s/strikeprice.asp). For put options, the holder enters a short position to sell the asset at the strike price.

## Practical Example: Trading Options on S&P 500 Futures

As an example of how these option contracts work, first consider an S&P 500 futures contract. The most popularly traded S&P 500 contract is called the E-mini S&P 500, and it allows a buyer to control an amount of cash worth 50 times the value of the S&P 500 Index. If the index value is $3,000, the e-mini contract controls $150,000 in cash. If the index rises by 1% to $3,030, the controlled cash value becomes $151,500. The difference here would be a $1,500 increase. Since the margin requirements to trade this futures contract are $6,300 (as of this writing), this increase would amount to a 25% gain.

But rather than tie up $6,300 in cash, buying an option on the index would be significantly less expensive. For example, when the index is priced at $3,000, suppose also that an option with the strike price of $3,010 might be quoted at $17.00 with two weeks before expiration. A buyer of this option would not need to put up the $6,300 in margin maintenance, but would only have to pay the option price. This price is $50 times every dollar spent (the same multiplier as the index). That means the the price of the option is $850 plus commissions and fees, about 85% less money tied up compared to the futures contract.

So although the option moves with the same degree of leverage ($50 for every $1 of the index), the leverage in the amount of cash used may be significantly greater. Were the index to rise to $3030 in a single day, as mentioned in a previous example, the price of the option could rise from $17.00, to $32.00. This would imply an increase of $750 in value, less than the gain on the futures contract alone, but compared to the $850 risked, it would represent an 88% increase instead of a 25% increase for the same amount of movement on the underlying index. In this way, depending on which option strike you buy, the money traded may or may not be leveraged to a greater extent than with the futures alone.

## Advanced Considerations for Options on Futures

As mentioned, there are many moving parts to consider when valuing an option on a futures contract. One of them is the [fair value](https://www.investopedia.com/terms/f/fairvalue.asp) of the futures contract compared to cash or the [spot price](https://www.investopedia.com/terms/s/spotprice.asp) of the underlying asset. The difference is called the [premium](https://www.investopedia.com/terms/p/premium.asp) on the futures contract.

However, options allow the owner to control a large amount of the underlying asset with a smaller amount of money thanks to superior [margin](https://www.investopedia.com/terms/m/margin.asp) rules (known as [SPAN margin](https://www.investopedia.com/terms/s/spanmargin.asp)). This provides additional leverage and profit potential. But with the potential for profit comes the potential for loss up to the full amount of the options contract purchased.

The key difference between [futures](https://www.investopedia.com/terms/f/futures.asp) and stock options is the change in underlying value represented by changes in the stock option price. A $1 change in a stock option is equivalent to $1 (per share), which is uniform for all stocks. Using the example of e-mini S&P 500 futures, a $1 change in price is worth $50 for each contract bought. This amount is not uniform for all futures and futures options markets. It is highly dependent on the amount of the [commodity](https://www.investopedia.com/terms/c/commodity.asp), index, or bond defined by each futures contract, and the specifications of that contract.

## The Bottom Line

Options on futures contracts give the holder the right, but not the obligation, to buy or sell a futures contract at a predetermined price before expiration. Investors in options on futures get the potential for significant profit or loss relative to the cash invested due to the leveraged nature of these securities. Furthermore, because this product incorporates two derivative securities, a futures contract and an options contract, investors should be completely familiar with it before engaging in trades.

> **Article Sources**
>
> 1.  Corporate Finance Institute. "[Options: Calls and Puts](https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/options-calls-and-puts/)."