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.
What is the least risky way to trade options? ›
The safest option strategy is one that involves limited risk, such as buying protective puts or employing conservative covered call writing.
How to reduce risk in futures trading? ›
Set a fixed proportion of your net worth for trading futures, and gauge your base risk limits. “The idea is each time you start trading, start with a smaller amount and pick some percentage that if you lose, you will say, 'That's it for now,'” Schwager says.
Which is better for beginners futures or options? ›
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.
What is the 80% rule in futures trading? ›
–If the market opens up inside of value and then trades out of value, the rule applies the same way. If the market can trade back inside value for two consecutive 30 minute periods, then it has an 80% chance of rotating to the other side of value.
Why is futures trading so hard? ›
Trading futures successfully requires your undivided attention to read and evaluate the markets effectively. Sometimes distractions are unavoidable, but you always want to have as few as possible when you are trading.
What is the most consistently profitable option strategy? ›
The most successful options strategy for consistent income generation is the covered call strategy. An investor sells call options against shares of a stock already owned in their portfolio with covered calls.
Why do most people fail at options trading? ›
Why Do Most People Fail At Options Trading? Most people fail at options trading because they have not taken the time to learn how options work and how volatility affects options pricing.
How do you never lose in option trading? ›
The option sellers stand a greater risk of losses when there is heavy movement in the market. So, if you have sold options, then always try to hedge your position to avoid such losses. For example, if you have sold at the money calls/puts, then try to buy far out of the money calls/puts to hedge your position.
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.
Futures can be traded almost 24 hours per day. There are short pauses but traders can trade them any time, day or night. The most popular traded hours are 9:00am to 4 pm est.
Why is trading futures very risky? ›
Market Risk: The most obvious risk with futures trading is that prices can be highly volatile, and changes are can be swift, adverse, and devastating. 11 This is because the market risk is magnified by leverage, when there's already enough to worry about when supply and demand shift.
Why do people buy futures instead of options? ›
The Bottom Line. While the advantages of options over futures are well-documented, the advantages of futures over options include their suitability for trading certain investments, fixed upfront trading costs, lack of time decay, liquidity, and easier pricing model.
What are the cons of futures options? ›
Disadvantages
- Complex: While anyone can trade futures, there are some complexities involved that can make this a complicated process. ...
- Over-Leverage: Leverage is a double-edged sword. ...
- Managing Expiry Dates: Most futures contracts have an expiry date that traders need to monitor.
Where futures and options are concerned, your level of tolerance of risk may be a contributing variable, but it's a given that futures are more risky than options. Even slight shifts that take place in the price of an underlying asset affect trading, more than that while trading in options.
How risky is it to trade futures? ›
Market Risk: The most obvious risk with futures trading is that prices can be highly volatile, and changes are can be swift, adverse, and devastating. 11 This is because the market risk is magnified by leverage, when there's already enough to worry about when supply and demand shift.
How to trade futures safely? ›
Form an opinion, do research, and understand the risks.
Like with any investment, you should develop a plan for your futures trade before you place it. Once you understand your risk tolerance, identify a profit or hedge objective and an exit plan should the trade go against you.
How do you trade with minimum risk? ›
It's advisable to begin with a relatively small amount in your trading account and only put in money you can afford to lose. Step 4: Begin trading with small positions. This reduces the risks of losing all your money on one or a series of bad trades while you're still learning.
Can you go negative trading futures? ›
All futures contracts are priced independently of each other, so you could have an instance where June is negative but July is positive. If both went negative, you would see negative IG prices on both futures contracts on the trading platform.
