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The Skinny On Options Modeling

Futures Option Pricing

The Skinny On Options Modeling

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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.

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