Future Option Trading Tutorial
Professional traders wager large sums of money on the movement of equity, commodity or currency prices, with the potential for very large returns on small initial investments. Trading is about more than just profit, however. Traders test their own brain power, predictive abilities and stomach linings as they leverage assets and explore techniques. For experienced traders, futures options can provide both a challenge and the potential for rapid profit.
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Options on Futures
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Futures contracts are arrangements to buy or sell a particular commodity for a set price at some point in the future. These contracts are both bets and guarantees -- the person buying the commodity bets that prices will go up and he will pay less than the market price when the trade is finalized. The person selling the commodity hopes the price will go down and that he can sell at higher than the market. In either case, the price is guaranteed: buyer and seller agree on something they can both live with.
Options on futures contracts give the option holder the right, but not the obligation, to buy or sell a particular futures contract for a particular price at some point in the future. In many ways this is a bet on a bet -- people who trade options bet that certain futures will become more or less desirable and they can sell them for a profit.
Risks and Benefits
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If you think of options trading on futures as gambling on gambling, you have some idea of the risks involved when trading. Options and their underlying futures contracts can be highly volatile, changing in value very quickly. In addition, underlying commodities -- grains, oil, and livestock along with less traditional items like stock indexes and currencies -- are effected by a wide variety of forces that can be extremely difficult to predict. It's not all bad news, however. For careful, well-educated investors, options on futures offer the possibility of very high returns on investment, and traders can leverage large asset values with a relatively small initial investment.
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Types of Futures Options
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As with traditional equity (stock) options, there are two major types of futures options: puts and calls. Puts are the right to sell a futures contract, while calls are the right to buy a futures contract. Trading strategies for futures are very similar to equity strategies; traders purchase call options in the hope that a contract price will go up, and puts when they believe the price will drop. They can then buy and sell the options themselves or exercise the options, buying and selling futures contracts for a profit. Traders can lower their risk by covering their calls and puts, which hold the underlying futures contracts, and by using straddle positions -- pairs of options or options and contracts that will benefit under opposing conditions.
How to Trade Futures Options
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You can trade options on futures using any one of a number of online trading platforms. In most cases, the ability to trade options is integrated with the ability to trade futures contracts themselves. Traders should verify the reputation of any online service through the National Futures Association BASIC program. Options traders pay fees, much like trading commissions, either by transaction or by options contract. Each trading program is different; online interfaces vary, as do fees and minimum account balance requirements. All reputable providers offer dummy accounts where you can learn to use the interface and practice trading using real-world data in real time. This allows traders to learn the business and develop trading strategies without risking any actual dollars.
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References
- CBOE: S&P 500 3 Month Variance Contracts
- CBOE: VIX Futures: The Basics
- "Futures" Magazine: Developing a Trading Plan; Rick Thachuk; April 2009
- "Opportunity and Risk: A Guide to Trading Futures and Options on Futures"; National Futures Association; 2009
- Commodity Futures Trading Commission: The Economic Purpose of Futures Markets and How They Work
