Excel Models
Futures Options
A futures option is the right, but not the obligation, to enter into a futures transaction at a predetermined futures price, by a predetermined date. The final date is usually set a few days before the expiration of the underlying futures contract (although there are exceptions for some financial assets).
Futures options are mostly American-style. Unlike a regular option, the underlying asset is not a stock or a commodity itself, but a futures contract. However, it can be used for price hedging in the same way as an option tied to a regular asset.
For example, if I am a cable manufacturer and enter into a long-term contract for cable supply at a fixed price, I need risk protection in case copper prices rise so that I don’t end up “sandwiched.” Therefore, I can hedge the price by buying a Call option on a copper futures contract. This is possible because copper spot prices and futures prices move almost along the same trajectory and are logically linked.
Why trade a futures option instead of an option directly on the underlying asset? The main reason is liquidity. Trading with futures options is more convenient—it avoids the logistics of physical delivery, and the market is larger and more active.
Why buy a futures option for risk hedging when I can directly buy a futures contract to lock in the copper purchase price? The difference is that when you buy a futures contract, you give up potential profit if copper prices fall. This potential profit comes at an additional cost. With futures, you pay nothing upfront (though you must deposit a margin as collateral), whereas with an option, you pay a premium.
In summary, the differences are as follows:
How does a futures option work?
If the futures price is higher than the predetermined strike price of the option, the holder can exercise the option, resulting in either:
- Cash settlement – calculated as the difference between the futures strike price and the final (previous day’s spot) price.
- Entering a futures contract – which can be closed immediately; since futures prices are marked to market daily, its value is determined by the difference between the current and previous day’s prices.
Below is an example of a Call option. A similar example for a Put option can be seen in the Excel file: Futures Options
Source: Options, Futures & Other Derivatives, John C. Hull
P.S.
The existence of futures options allows one to determine the value of the risk that a supplier assumes when agreeing to fix the maximum price of a product over the long term.
For example, from the table below showing high-quality copper futures options trading data, it is evident that hedging the price ceiling without a purchase obligation is more than 15% of the asset’s value.
Source: Barchart
