Trading futures can be very profitable for traders, and the futures exchanges allow trading on a wide range of commodity and financial instruments. On the other side, a futures trade can produce very large losses if a trader bets wrong. Options on futures allow a trader to participate in the upside potential of a futures contract with limited risk on the downside.
Getting a Futures Account
To buy futures options, you must open a commodity futures trading account with a registered commodity futures broker. Futures brokers must be registered with the Commodity Futures Trading Commission and the National Futures Association. Although some stock brokerage firms also offer futures trading, the commodity broker business tends to be separate from the stock market brokers. After acknowledging a disclosure that you understand the risks of futures and options trading, you can open and account and deposit money for trading.
A futures contract gives the contract holder the right to buy or deliver a specified amount of the underlying product or security. For example, the crude oil futures contract is for the delivery of 1,000 barrels of oil. The buyer of an oil futures contract will receive the oil when the contract matures, and a seller must deliver the oil. A futures trader buys or sells based on whether he believes the price of oil will go up or down and closes out the trade before the contract matures. The cost to trade a futures contract is called a margin deposit.
Options on Futures
The futures exchanges also offer put and call option trading. The options contracts are for the delivery of the underlying futures contract. A call option is purchased if the value of the underlying futures contract is expected to increase in value. A put option is purchased to profit from a declining futures value. Each option contract is for one underlying futures contract and if the option is exercised, the investor will receive the futures contract. An option can also be sold be for exercise to take the profit without converting the option to a futures contract.
Buying Futures Options
Futures options are a less-risky, lower-cost way to profit from a change in a specific futures price. Using options protects a less-experienced investor or trader from the large losses possible with directly trading futures. The downside of buying options is that the futures contract must increase by at least the cost of the options contract to be a profitable investment. Someone new to futures and futures options trading should discuss her goals with a representative of the futures brokerage firm. Futures brokers will provide new traders with advice and guidance.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.