Options on futures are the insurance policy of traders in futures. If you use them effectively as part of your trading strategy they can help you manage the inherent risk of investing in futures.
Options provide traders with the rights and obligation to sell futures. An option is simply a contract, much like a futures is a contract. When you buy an option you are paying for certain rights and you receive certain responsibilities. To illustrate what a futures option is, imagine you are buying a new property. You love the house, the property is perfect for your needs. There is only one problem, you do not have the financing in place yet. You are worried somebody else will buy the property if you don’t, so what do you do? You ask the owner for an option for the land in exchange for a percentage of the property’s selling price. In exchange the owner agrees to not sell the property to anybody during the period of time you agree on in the contract. At this stage you have three main options, buy the house, not buy the house or sell the option to buy to somebody else. If you wait until the option expires, you lose exclusivity over the property and it returns to the market.
Something very similar occurs when you trade in futures options.
To summarize, there are four main positions you can adopt in an option you should remember. There are long calls, which give you the right to buy futures, long puts, which give you the right to sell, short calls, which give you the obligation to sell, and short puts, which give you the obligation to buy.
Option Types
The situation we described in our real estate example is very similar to an over-the-counter option, or OTC. In OTC the options contract is negotiated directly between the seller and the buyer. Options-on-futures, on the other hand, are sold and bough at an exchange market. The main advantage of exchange traded options is you can easily sell the option to a third party. Although in theory you can also do this with an over the counter option, you have the responsibility to find a party interested in buying. With exchange options buyers are usually not hard to come by. Exchange options also allow you to play the short side of trading. This means that if you think the market is going to drop , you can buy an option to buy the futures at a discounted rate. However, with over the counter options it is much harder to sell that kind of deal to the seller.
