This segment focuses on the pricing of futures options, how they differ from equity options and what adjustments need to be made to the Black-Scholes model to account for the differences. Some other important differences are noted as well. This segment is a must for anyone interested in trading options on futures.
The price of a futures contract is related to its cash or spot price by the holding costs for that product including such things as storage and/or insurance costs, dividends or yields, interest costs and the time until the futures contract expires. Some of these hold true for some futures and not for others. Dividends are a factor for the e-mini S&P 500 but not for corn. There is a storage price for corn but not e-minis.
Black-Scholes was designed for equity options. It includes some things that are already factored into the price of the future so that needs to be accounted for. TP explained how to do that and provided the equation and highlighted the main difference.
Because there is no interest cost to finance buying the future at the strike price, the futures model also omits the discount factor from the strike price. Also, there is no interest charge as there would be when you buy stock (which reduces your cash balance) since the margin for a future isn’t deducted from cash. TP also explained that without another adjustment for interest the model would underprice puts and overprice calls. He provided the formulas.
Every option is priced off its hedge. That is simple in equities. A GMCR call is priced off of GMCR. It isn’t so straightforward in futures, especially when discussing the agricultural futures when one has to account for new crop and old crop. You need to price the options off the future that expires on or after the expiration of the options. So, Nov /ZB options are priced off Dec /ZB futures, not Sep /ZB futures or March /ZB futures. This is critical for VIX options and important for futures in steep contango or backwardation.
Should you look at the prices and the relationship between the calls, puts and the underlying appears to be off you are likely looking at the wrong futures month. Put-Call parity (call – put + strike = future) is maintained when the options are compared to their corresponding (hedging) future. TP demonstrated this using an example from the VIX.
Watch this segment of “The Skinny on Options Modeling” with Tom Sosnoff, Tony Battista and Tom Preston (TP) for a better understanding of futures and the pricing of futures options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastytrade is a trademark/servicemark owned by tastytrade.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).
tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.