I am currently studying different types of option-related derivatives and I am quite confused about the notion of “futures options”.

My textbook says that

A futures option is the right, but not the obligation, to enter into a futures contract at a certain futures price by a certain date.

My interpretation is that the difference between a futures option and a stock option is that the underlying asset now becomes the futures contract, instead of the stock. However, according to the main characteristics of a futures contract,

it costs a trader nothing (except possibly for margin requirements) to enter into a futures contract.

Therefore, what is meant by a “futures price”? A future should be a free contract under which the buyer must buy/sell an asset at a predetermined strike price in the future.

I am confused. Any ideas?

  • $\begingroup$ Possibly over-thinking this. Most eg index, bond (not swaption) and commodity options are options on the futures. Consider Gold. Instead of taking out my option on spot bullion, or on XAUUSD in FX, I do it on the GC futures. The future will have a slightly different price today to spot; but will settle at spot on expiry. $\endgroup$ – demully Oct 5 '19 at 7:25
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    $\begingroup$ A futures price is , in your words, the predetermined strike price at which you will buy/sell the underlying asset. This price moves every day according to the marketplace view of the fair value of this strike price. $\endgroup$ – dm63 Oct 5 '19 at 16:17
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    $\begingroup$ @dm63, consider posting this as an answer. $\endgroup$ – Richard Hardy Oct 20 '19 at 10:11

Firstly the quotes you stated are accurate.

Secondly, most people think of a price as amount of cash that you exchange for a thing. However, a futures contract is a contract. It is a legal agreement. The 'price' is just a number in that legal contract.

When you exercise an option on a futures contract, you enter into a contract where the 'price' is the same as the strike price of the option contract.

My interpretation is that the difference between a futures option and a stock option is that the underlying asset now becomes the futures contract, instead of the stock

To be precise, the underlying is the futures contract, or rather more precisely, a futures contract that will be entered into if the option contract is exercised (ie, the futures contract details are known when the option is created / sold).

Futures contracts require asset flows from party to exchange (or vice versa) at specific times. The requirements are initial margin (cash), then variation margin as the prices changes daily (cash), then potentially final settlement (cash or commodity depending on the contract specifications set by the exchange).

So you could say that the contract is initially 'free', because there is no initial upfront cash cost to 'buy' a futures contract, but its sloppy nomenclature. You enter into one (long or short) at a given price and then post/receive margin as required.

For the specific example of entering into a futures contract as a result of exercising an option contract, the 'price' in that futures contract will be the strike price of the options contract. This will most likely not be the current market price, and then the futures contract position can be exited by buying or selling the same amount (if it was a put or a call respectively), with the difference between the strike and the current market price being the profit or loss. Obviously you should not exercise the option if the strike is deep 'out of the money'.

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