Futures Options

A futures option is a contract that gives its buyer the right, but not the obligation, to enter into a futures contract at a set price, by a set date. A futures contract is itself an agreement to buy or sell something — say, crude oil, gold, or the S&P 500 index — at a fixed price on a future date. So a futures option is one layer removed from the actual commodity or index: it is an option whose "underlying" is not a stock or ETF, but another derivative, the futures contract.

Like a stock option, a futures option comes in two flavors. A call gives the right to go long the futures contract (buy it) at the strike price. A put gives the right to go short the futures contract (sell it) at the strike price. The buyer pays a premium for this right, and can exercise it, let it expire worthless, or — far more commonly — simply trade out of the option before expiration, since it has its own resellable market price.

The nuance that trips people up is what happens at expiration. Instead of settling into shares, like a stock option would, an exercised futures option settles into a futures position — a long or short futures contract at the strike price. That new futures position then carries its own margin requirements and its own daily mark-to-market cash flows, which is a very different mechanic from stock options and catches people off guard if they didn't plan for it.

Another wrinkle: futures options often expire before the underlying futures contract itself expires, and the specific expiration and exercise mechanics (American-style versus European-style, and the exact settlement calendar) vary by exchange and by product, so they need to be checked contract by contract rather than assumed.