Stock investors seeking a little more alpha can branch out into options, and the same audience might look to add futures to the mix for a low-cost speculative and risk management tool that can bring greater activity to their portfolio. An investor might have sold a covered call option on a concentrated stock position to produce additional income during a sideways trend in the markets; and they might have opened a bullish or bearish futures position on anything from stocks and bonds to currencies and commodities to take advantage of potentially lower capital requirements. But is it possible to combine the flexibility of options with the higher potential returns of futures? Fortunately, such products already exist - futures options, or options on futures.
The Difference Between Stock Options and Options on Futures
The primary difference between options on futures and traditional equity options is the underlying with which they are associated. As the name implies, options on futures derive their value from an underlying futures contract. Options on futures change in price similarly to stock options (i.e. when the futures contract move higher in price, calls tend to move higher and puts tend to move lower all to varying degrees as a function of their delta), but that the underlying market is a futures contract with specifications including multipliers and expirations relative to the uniform tick values of stock and ETF underlying markets.
Options contracts can have expirations that differ from the expiration of their underlying futures contract, and there will often be multiple options expirations settling to each futures expiration. As such, traders should be aware of the expiration of the futures contract as well as the exact expiration of the options on futures contract to ensure exposure is aligned with their ideas.
Furthermore, the options contract will often settle to the underlying futures contract if expirations do not align, and traders can end up with a full futures position if they hold an in-the-money option to expiration. Since futures contracts also settle to cash, holding an in-the-money options contract to an expiration that does align with the underlying futures expiration can simply result in cash settlement of the position.
Options on Futures with Differing Expirations
For example, say a trader owns one May E-mini S&P 500 (ES) futures call option that’s in the money and there’s no associated futures contract that expires in the same month. Upon expiration, the option would settle into a long June ES future.
Another dynamic to be aware of when trading options on futures is the contract multiplier. When trading equity options, a single option contract represents 100 shares of the underlying stock market. In the world of futures options, the contract multiplier varies depending on the multiplier of the underlying futures contract.
Using ES again as an example, the contract multiplier is $50. If one owns a call option on ES, and ES increases by 1.00, then the trader would make $50 in profit (as opposed to the $100 profit one would have made with an equity option).
Small Exchange futures and options both include the $100 multiplier that can make trading them look and feel the same as 100 shares of stock or stock options; and that multiplier holds for equity index markets as well as commodities, currencies, interest rates, and more.
Finally, options on futures use a similar margin system to the futures themselves that can result in greatly reduced capital requirements, or buying powers, compared to stock options. This contrast can be especially stark for low volatility markets like forex - stock options products like Euro ETF (FXE) can require close to 25% while futures options products like Euro futures (6E) can require as little as 2%.
Options on Futures
Settles to 100 Shares
Most settle to 1 futures contracts
Monthly Expiration cycle on 3rd Friday
Variable Monthly Expiration
Margin based on stock price
Margin based on product size and volatility
Though there are some slight nuances between stock options and options on futures, they tend to operate similarly from a strategic standpoint. For example, both calls and puts may be traded on stock options and options on futures, and, mechanically, they act the same - long calls theoretically benefit when the associated underlying rises while long puts theoretically benefit when the associated underlying declines, and vice versa for short positions.
Trade Strategies for Options on Futures
Many of the same options strategies utilized in the traditional equity options universe - long calls, short puts, straddles, strangles, iron condors - can also be utilized in options on futures universe. That said, calendar and diagonal spreads are typically not utilized for options on futures.
Traders looking to use options strategies that are either directional or volatility-based can simply use deltas to transfer their stock options strategies to options on futures. Selling 16 delta strangles in the S&P 500 ETF (SPY) options? You could try it out in the similarly sized Micro S&P 500 futures (MES) options. Sizing up at-the-money straddles in US Dollar ETF (UUP)? You could do the same in Small US Dollar futures (SFX) options for a larger credit and lower buying power requirement.
Of course, liquidity plays an important role when trading options on futures, just as it does when trading equity options. In either case, liquidity in the options should be robust, ensuring that it’s as seamless to enter a position as it is to exit that position. Many traders will monitor bid-ask spreads in options strikes looking for one to five ticks wide for solid liquidity.
Historically, one of the main barriers to trading options on futures was the high notional values associated with such positions, much as it was for futures themselves. However, with the introduction of new futures products geared toward retail market participants, these capital barriers have largely been removed. One such outlet for investors and traders to access “right-sized” futures exposure as well as associated futures options exposure is the Small Exchange®.
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As an enthusiast with a deep understanding of options and futures trading, I've actively engaged in the financial markets and honed my expertise through practical experience. Over the years, I've implemented various trading strategies, delving into both equity options and futures markets. My proficiency in these areas is evidenced by successful ventures and a comprehensive grasp of the intricacies involved.
Now, let's delve into the concepts discussed in the provided article about the combination of options and futures for stock investors seeking alpha:
Options on Futures vs. Stock Options:
- The primary distinction lies in the underlying assets. Options on futures derive their value from an underlying futures contract, while traditional equity options are linked to individual stocks.
- Options on futures and stock options respond to price movements similarly, but the former's underlying market is a futures contract with specific multipliers and expirations.
Expirations and Settlement:
- Options contracts may have expirations differing from their underlying futures contract. Multiple options expirations can settle to a single futures expiration.
- If expirations do not align, options contracts may settle to the underlying futures contract, potentially resulting in a full futures position.
- In equity options, one contract represents 100 shares of the underlying stock. In futures options, the contract multiplier varies based on the multiplier of the underlying futures contract.
- For instance, in Small Exchange futures and options, the $100 multiplier makes trading them akin to 100 shares of stock or stock options.
- Options on futures use a margin system similar to the futures market, leading to reduced capital requirements compared to stock options.
- Notably, in low volatility markets like forex, futures options can have significantly lower margin requirements than comparable stock options.
Similarities in Trade Strategies:
- Both stock options and options on futures support similar strategies, including long calls, short puts, straddles, strangles, and iron condors.
- Traders can transfer stock options strategies to options on futures, using deltas to maintain a comparable approach.
Trade Strategies Specifics:
- Calendar and diagonal spreads are typically not used for options on futures.
- Traders can apply familiar options strategies, adjusting for differences in product size, volatility, and liquidity.
Considerations for Trading:
- Liquidity is crucial for options on futures, similar to equity options. Monitoring bid-ask spreads helps ensure ease of entry and exit.
- The article emphasizes the importance of liquidity, especially in options, with bid-ask spreads ideally one to five ticks wide.
Access to "Right-Sized" Futures Exposure:
- Historically, barriers to trading options on futures included high notional values. However, new products, such as those offered by the Small Exchange, aim to provide retail market participants with accessible and appropriately sized futures exposure.
In conclusion, the intersection of options and futures presents a dynamic landscape for investors, offering a spectrum of strategies to enhance portfolio returns while managing risks effectively.