There are many important differences between listed options based on an underlying stock, and options on a futures contract. With a stock, the option is tied to 100 shares of stock and is a derivative of those shares. A futures option, however, is a type of derivative on a derivative. The futures contract itself exists as a contract representing an underlying commodity or financial instrument (foreign currency or interest rate, for example). So when you trade an option on a future, your leverage is compounded. This can be a great advantage if the price is moving in the direction you desire, but it can also compound your losses when your timing is wrong.
Smart Investor Tip
The futures option is a derivative on a derivative.
This expands the potential for profits — as well as risks.
The cautionary aspects of futures options are the same as those for stock-based options. You face the same problems of time decay in long positions and the same risks of exercise in short positions. Just as many would-be stock option traders have opted instead to invest in stock-based exchange-traded funds (ETFs) or index funds, many traders interested in the futures market have channeled their capital into futures-based ETFs. For many, this makes sense. If you do not want to assume the risks of buying and holding stocks, various kinds of equity mutual funds or ETFs are appealing. And if you find the futures market too complex, then a handful of futures-based ETFs could be the perfect solution. However, some options traders will be attracted to the exponential leverage of futures on options.
Another important distinction is that the futures market is often far more volatile than the stock market, with valuation potentially moving rapidly in either direction. For example, consider the recent history of the most popularly traded commodity, oil. Between 2007 and 2008, prices doubled to over $145 per barrel, and then by the end of 2008, fell more than $110 to under $35 per barrel. While some stocks have experienced similar upward and downward movement, it is much more common in the futures market. So if you had bought calls early in 2007 and then sold at the top, and replaced them with oil futures puts, you could have made an incredible profit. Hindsight is always perfect, however, and during the turbulent price changes of 2007-2008, uncertainty and bad timing made such perfect decisions unlikely.
Smart Investor Tip
Traditional explanations of the futures market cite the equilibrium between buyers and sellers to explain why the market is more stable than the stock market. Recent history shows, however, that this assumption is not always valid. Futures can be just as volatile as stocks, and at times even more volatile.
Anyone familiar with options on underlying stock is probably quite comfortable with the knowledge that every option is based on 100 shares of stock. A complexity in the futures market is that underlying increments are different for each commodity, given its nature and method of trading. This makes the futures option industry much more complex than the stock option industry. As with any new and unfamiliar market, a lack of understanding about these basics is itself a very serious risk.
Trading increments are based on the specific future itself. Some examples:
| Futures Trading Units | ||
| Commodity | Trading Unit | |
| Energy | ||
| Unleaded gas | Gallons | |
| Heating oil | Gallons | |
| Crude oil | Barrels | |
| Natural gas | MMBTUs (millions of | |
| British Thermal Units) | ||
| Agricultural | ||
| Sugar | Pounds | |
| Corn | Pounds | |
| Soybean oil | Pounds | |
| Wheat | Bushels | |
| Oats | Bushels | |
| Soybeans | Bushels | |
| Soybean meal | Tons | |
| Lumber | b.f. (board feet) | |
| Imports and Tropical Commodities | ||
| Frozen concentrated | Pounds | |
| orange juice (FCOJ) | ||
| Coffee | Pounds | |
| Cotton | Pounds | |
| Cocoa | MTs (metric tons) | |
| Cattle | ||
| Feeder cattle | Pounds | |
| Frozen pork bellies | Pounds | |
| Lean hogs | Pounds | |
| Lice cattle | Pounds | |
| Precious Metals | ||
| Aluminum | MTs | |
| Copper | MTs | |
| Lead | MTs | |
| Nickel | MTs | |
| Zinc | MTs | |
| Gold | t.oz. (troy ounces) | |
| Platinum | t.oz. | |
| Silver | t.oz. | |
In addition to the many variations in trading units for commodities, an active market in financial futures complicates the picture further. Currency rate futures are traded on a relative basis (e.g., valuation changes between the U.S. dollar and the British pound). Interest rates trade on percentage rise and fall of known rates, such as Treasury securities. A number of index futures trade based on price movement in numerous stock market indices, such as the Dow Jones Industrials, the S&P 500, and other tracking and benchmark indices. Another form of financial futures are futures on individual stocks, usually associated with 100 shares of the underlying. Many traders like futures because of the liberalized margin requirements. Rather than the 50 percent margin needed for stocks, stock futures can be traded with 20 percent on deposit. You can also short stock with a futures contract without needing to borrow 100 shares of stock. In many ways, stock futures are very much like options. However, settlement rules are not the same, and regulatory oversight resides with the Commodity Futures Trading Commission (CFTC) rather than with the Securities and Exchange Commission (SEC).
Understanding the trading units is only part of the challenge in trading options on futures. With stocks, the increment is standardized, meaning that every listed option is related to 100 shares of the underlying stock. For futures, the incremental unit base is different in each case. So for one futures contract, the trading unit, the contract may be traded in a unit increment of 100, and for another it could be 5,000. Naturally, these distinctions also affect the total cost of the futures option.
Another distinction is the nature of the underlying security. While 100 shares of stock represent an equity position in the company itself, an increment of a futures contract on which options may be bought or sold does not contain any equity, only the obligatory nature of the futures contract itself. This contract is a future obligation to either accept delivery or to provide delivery of the underlying commodity. With stock, delivery means exchanging 100 shares in satisfaction of an exercised option. In the futures business, delivery rarely occurs because it means actually trading the commodity on which the futures contract and the option are based. Because this rarely occurs, exercising a futures option or allowing a short position to go into exercise is not an acceptable outcome in most situations. So while many stock options writers accept the possibility of exercise, the same is not true of futures options writers. In fact, only about 3 percent of all futures contracts result in actual delivery of the underlying commodity. So a majority of options traders allow expiration, sell, or roll forward their positions to avoid exercise.
Smart Investor Tip
The underling security for a stock-based option (100 shares of stock) has permanent, tangible value. But the underlying security in a futures option (a futures contract) is both intangible and finite. This is a very important distinction between the two markets.
The actual risk of a short futures option writer having to take delivery of a massive quantity of a commodity is small. Even in the few instances when a short futures option is kept open beyond the notice date, the commodity exchange issues an intent to deliver. Even if that date passes, the commodities broker will issue what is called a retender notice to cancel the obligation to take delivery.
The retender involves a fee, but that is invariably preferable to having to accept delivery. Unlike stock-based options, where delivery is automatic, a futures-based option is unlikely to go through delivery. This leniency is built into the market because a majority of traders could not afford the high cost of physical delivery, so actually making such a delivery would be a disadvantage for everyone.
Options traders are constantly aware of expiration, especially as the expiration date approaches. The same is true for futures options traders. However, while stock continues to exist indefinitely, the underlying futures contract has its own expiration date. In some cases, the futures contract and related options expire on the same day. In other cases, the expiration dates for futures and futures options may be different. Expiration is also distinct for futures options in another way. If your short stock-based call option is exercised and you receive stock, you have the right to hold those shares of stock as long as you wish. However, with a futures-based call, accepting delivery is not normally a viable outcome, so an in-the-money futures short call has to be rolled forward or sold.
In one respect, the fact that exercise of a short option is unlikely (and automatic exercise does not occur), futures-based option sellers have a distinct advantage over stock-based short sellers. You can roll short positions forward indefinitely, at least in theory. However, a serious risk exists in cases where prices rise rapidly and significantly. A look back at markets in 2007-2008 for energy and agricultural commodities makes this case. Eventually, a deep in-the-money option may have to be closed, for example, when the price level no longer is available because commodity values have moved far beyond the original price ranges.
A final important distinction has to be made: anyone trading options on long stock positions earns dividends when applicable, and the dividend often represents a significant portion of overall return (when included with capital gains and option premium in covered calls and similar strategies). So for traders with a portfolio of stocks, the dividend is a major advantage to keep in mind when comparing potential profits and risks. However, futures contracts as an underlying security for options trading do not pay dividends. While this is widely known by traders, the relative value and distinction is easily overlooked or ignored.
Smart Investor Tip
Don’t overlook the importance of dividend income from long positions in the underlying stock, as a point of comparison of profit and risk, between stock-based and futures-based option trading.
In situations when potential profit is similar or identical between stock and futures options trading, the dividend on long stock positions may make all the difference and, when considered in the overall comparison, could make it preferable to trade the better-known stock-based option.