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Options on derivatives: futures
The options market overview illustration is reproduced here for the sake of orientation (see Figure 9).
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.
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:
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.
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).
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.
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).
Table 6: Option specifications
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