Diversifying with Options on Futures
May 20, 2019
Futures offer a great avenue for diversifying our portfolios, especially if we are already trading heavily in stock, ETFs, and associated options.
Many of the same strategies which we utilize when trading other financial products are applicable to futures, which makes the transition to this niche of the financial markets fairly simple.
If you're a heavy trader of options, then futures can also be attractive due to the existence of "options on futures."
Not too long ago, we provided a broad overview of futures options, in a post titled “Introducing Options on Futures.” If you haven’t seen that piece, we recommend reviewing it when your schedule allows. But if you are looking to move to the next level regarding futures options, then today's post is for you - particularly if you want to better understand how futures options differ from equity options.
At the highest level, the main difference between futures options and equity options is the underlying with which they are associated, and settle into. As the name implies, futures options derive their value from the exact futures contract they are associated with.
One wrinkle we need to keep in mind is that futures contracts aren't usually listed for every month in a given year. So traders always need to be aware of the exact expiration of the futures contract as well as the futures option in question.
The main thing to understand is that futures options expire in cash when the underlying future and the option on that future expire in the same month. If the futures contract and futures option expire in different months, the option will instead settle into the futures (i.e. not cash).
Looking at an example, imagine we own a February /ES futures call option and there is no associated futures contract that expires in the same month. That means upon expiration the option will settle into a long March /ES future.
Another dynamic to be aware of when trading options on futures is the contract specs, and in particular, the contract multiplier. When trading equity options, we know that a single option contract represents 100 shares of the underlying.
In the world of options on futures, the contract multiplier varies depending on the exact product being traded. Using /ES again as an example, the contract multiplier in this case is $50. If we own a call option on /ES, and it increases in value by $1, then we will make $50 in profit (as opposed to the $100 we would have made with an equity option).
If you want to learn more about the nuances of switching from equity options to futures options, we also recommend a previous installment of Best Practices which discusses these considerations in more detail. The slide below, taken from that episode, provides a summary of some key differences:
As one can see in the above slide, there are nuances that need to be understood before transitioning from equity options to futures options. However, there are a great deal of similarities between the two as well, which should ease the transition.
For example, both calls and puts may be traded via options on futures and mechanically speaking they act the same - meaning a long call benefits when the underlying rises, and a long put benefits when the underlying declines.
Another similarity is liquidity, which is paramount when trading futures options - just as it is when trading equity options. And just like with equity options, there will be instances in which the liquidity of a given futures option may be inadequate, and we therefore need to take a pass on the trade.
The slide below highlights the futures markets with the highest associated option volumes:
The option volume data shown above is consistent with volume data from the underlying futures contracts themselves - meaning the heaviest futures volumes on any given mirror the top options products: E-mini S&P 500, 10-Year Treasury Note, and Crude Oil.
The main takeaway is that traders need to ensure that the underlying futures contract, and the associated futures option, both have adequate liquidity before considering a potential trade in either market.
If you want to learn more about options on futures, there’s a plethora of additional content available through the search functionality on the tastytrade homepage. If you are looking to see how trade ideas are generated in the options on futures universe a new episode from the Market Mindset series is well worth your time.
Additionally, the links below should prove useful:
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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