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Options on derivatives: futures

Introduction

The options market overview illustration is reproduced here for the sake of orientation (see Figure 9).

options

Figure 9: options

As noted, all futures markets are formalised markets. Options are available on virtually all futures, and most of these options are exchange-traded. The word "most" is used here because in some markets OTC options on futures also exist.

With options on futures (also called "futures options") the underlying instrument is a futures contract (not the underlying instrument of the future). The relevant price is therefore the price of the futures contract (and not the price of the underlying instrument or index). The futures contract usually matures a short while after the expiration of the futures option. When the holder of a call futures option exercises the option, the writer is obligated to deliver to the holder of the option:

• A long position in the underlying futures contract.

• Plus an amount that is equal to the difference between the last MTM50 futures price and the exercise price (futures price - exercise price).

Conversely, when the holder of a put on a future exercises the option, the writer is obligated to deliver to the holder of the put:

• A short position in the underlying futures contract.

• Plus an amount that is equal to the difference between the exercise price and the last MTM futures price (exercise price - futures price).

In practice, however, most options on futures are settled in cash.

It will be recalled that the futures market may be categorised (with examples included) as shown in Table 4.

FINANCIAL

COMMODITIES

Interest rate

Equity / share

Foreign currencies

Agricultural

Metals and energy

Physical

Physical

Physical

Grains and oilseeds

Physical -Metals

Treasury bonds

Various specific

Japanese yen

Wheat

Gold

Treasury notes

shares

DM

Soybeans

Platinum

Treasury bills

British pound

Corn (maize)

Silver

Federal funds

Index (notional)

Swiss franc

Copper

Canadian govt

DJ Industrial

French franc

Livestock and meat

Aluminium

bond

S&P 500

Australian dollar

Cattle - live

Palladium

Eurodollar

NASDAQ 100

Brazilian real

Hogs - lean

Euromark

CAC-40

Mexican peso

Pork bellies

Physical -Energy

Euroyen

DAX-30

Sterling/mark cross

Crude oil - light

Eurobond

FTSE100

rate

Food and fibre

sweet

Toronto 35

Cocoa

Natural gas

Index (notional)

Nikkei 225

Index (notional)

Coffee

Brent crude

Short sterling bond

NYSE

US dollar index

Sugar

Propane

index

Cotton

Long sterling bond

Orange juice

Index (notional)

index

CRB index

Municipal bond

index

Physical = the actual instrument, currency, commodity. Index = indices of exchanges, etc. CRB index = Commodity Research Bureau.

Table 4: Examples of futures contracts

As noted, options are available on virtually all futures. In the US the most active options on futures contracts are the options on treasury bond futures and treasury note futures, options on the Eurodollar futures, and options on the futures contracts on corn, soybeans, and crude oil.

It may be useful to provide an example of an option on futures deal:

Example

An investor requiring a general equity / share exposure to the extent of LCC 1 million decides to acquire this exposure through the purchase of call options on the All Share Index (ALSI) future. If the index is currently recorded at 5 000, she would require 20 call option contracts (20 x LCC 10 x 5000 = R1 000 000) (remember that one ALSI futures contract is equal to LCC 10 times the index value).

Because the investor is buying the right to purchase the future and has no obligation in this regard, she pays a premium to the writer. In this example we make the assumption that the premium is LCC 1 500 per contract (LCC 30 000 for 20 contracts). The investor is thus paying LCC 30 000 for the right to purchase 20 ALSI futures contracts at an exercise or strike price of 5000 on or before the expiry date of the options contract.

It will be evident that the premium per contract of LCC 1 500 translates into 150 points in the all share index (LCC 1 500 / LCC 10 per point). Thus, the investor's breakeven price is 5150 (5000 + 150). This can be depicted as the plum-colored line in the payoff diagrams own in Figure 10.

payoff profile of writer and holder of call option

Figure 10: payoff profile of writer and holder of call option

Assuming that the buyer (investor) holds the contracts to expiry:

• If the price closes at or below 5000 she will not exercise. She incurs a loss equal to the premium paid, i.e. LCC 1 500 per contract.

• If the price closes between 5000 and 5150 she will exercise the options and recover a portion of the premium.

• If the market closes at a price above 5150 she will exercise and make a profit. For example, if the price at expiry is 5400, her profit is LCC 2 500 per contract [i.e. LCC 10 x (5400 - 5150)].

The risk profile of the writer is exactly the reverse of that of the holder. As can be seen in Figure 10:

• The writer makes a profit of LCC 1 500 (the premium) per contract if the price closes at or below 5000.

• The writer makes a profit of less than LCC 1 500 per contract if the price closes at between 5000 and 5150. This is because the holder will exercise between these two prices in order to recover a portion of her premium.

• The writer makes a loss if the price rises above 5150. For example, if the price closes at 5600, the writer will make a loss of LCC 4 500 [LCC 10 x (5600 - 5150)] per contract.

It will be apparent that the investor gained her LCC 1 million exposure with a monetary outlay of LCC 30 000. Thus, she is able to invest the balance of LCC 970 000 in the money market and receive the current interest rate. The money market rate (rfr) is thus an important input in the pricing of options (as seen above).

payoff profile of writer and holder of call option

Figure 11: payoff profile of writer and holder of call option

The buyer of a put option has a risk profile which is the converse of that represented by a call option (see Figure 11). For example, an investor wanting to hedge his LCC 1 million equity / share exposure (i.e. anticipating that share prices will fall) would buy 20 put option contracts on the ALSI future (assuming the strike price to be 5000). She is thus hedged to the extent of LCC 10 x 20 x 5000 = LCC 1 000 000. She thus has the right, but not the obligation, to sell to the writer (seller) 20 ALSI futures contracts on or before the expiry date of the options contracts. Assuming that the premium paid is LCC 1 500 per contract, her risk profile is as depicted in Figure 11.

As far as the holder is concerned:

• If the price closes at 5000 or higher, she will not exercise and the loss is limited to LCC 1 500 per contract.

• If the price closes at between 5000 and 4850, she will exercise and recover a portion of the premium.

• If the price falls below 4850 she makes a profit equal to LCC 10 per point per contract.

Conversely, the writer of the put options will profit to the extent of LCC 1 500 per contract if the price at close is 5000 or better, profit less than LCC 1 500 at a price between 4850 and 5000 and incur a loss at a price below 4850 to the extent of LCC 10 per point per contract.

Options on futures are also subject to margin requirements. These are the same as for the underlying futures.

Option specifications

As will be understood, options contracts take on many of the features of the underlying instruments, i.e. the futures contracts. The below-mentioned option specifications should therefore be read together with the futures contract specifications (see Table 651).

The two basic uses of options on futures are to protect a future investment's return from falling interest rates / rising prices (call option), and to protect against rising interest rates / falling prices (put options).

The same time and date as the underlying futures contract

American

Both a call and a put at each strike (exercise)

Strike price units

Strike prices are specified in the units of quotation of the underlying futures contract

Strike price intervals

Strike prices are at fixed intervals.

Live strikes

Three strike prices are "live", i.e. are accommodated on the screens. The corresponding options are "at", "in" and "out" of the money, and are referred to as "strike 1", "strike 2" and "strike 3" on the screens. A separate screen gives the value of the strike price associated with each of the three.

Strike shifts

The live strikes are shifted, and new strikes introduced (if necessary) whenever the underlying financial instrument's price:

• Moves beyond either of the away-from-the-money strikes or

• Is consistently closer to an away-from-the-money strike than to the at-the-money strike for one trading day.

Shifts are not normally more frequent than daily, and are made overnight. All shifts are made at the exchange's discretion.

Free-format screens

Quotations for options whose strike prices are not live are entered onto one or more free-format screens

Contract size

Each option is on one contract of its underlying financial instrument

Standard lot size

(Number of options that quotations are good for). The same as the underlying financial instrument's standard lot size.

Quotations

Quotations are in whole rands per option

Settlement of premiums

Through the mark to market process over the life of the option

Mark-to-market

Daily according to the option's mark to market price (i.e. the same as for futures)

Determination of mark to market prices

• Quoted doubles are used where available

• Implied volatilities are calculated from available prices to value options (on the same underlying financial instrument) lacking quotes

• Exchange has the discretion to override the former and to specify volatilities overriding the latter

Exercise

May be exercised at any time until expiry. A client's option is exercised through his member directly with the exchange

Settlement on exercise

Into the underlying financial instrument

Assignment

Options exercised will be randomly assigned to short positions in the same option. Assigned holders (or their members), and their clearing members, will be notified immediately. Assignment will be in standard lot sizes as far as possible.

Automatic exercise

All in-the-money options will be automatically exercised (into the underlying financial instrument) on expiry. This happens before the close out by the exchange of positions in futures contracts.

Margins

Option positions are subject to the same initial margin requirements as their underlying financial instruments. However, the potential profit/loss profile of options is recognised. Margins are also affected by volatility margin requirements.

Source: Safex / JSE.

Table 6: Option specifications

 
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