FD/U3 Topic 3 Option on Futures, Interest Rate Options
Option on Futures
Options on Futures. This is an option contract based on a single futures contract. The buyer has the right (but not the obligation) to take on a particular futures position of a commodity, currency, index, or financial instrument, at a specified price (the strike price) any time before the option expires. The futures option seller is obliged to adopt the opposite futures position when the buyer exercises this right. Options on futures are traded on the same exchanges where the original futures contracts are traded. The options contracts match the underlying futures contracts in regard to quantity, expiration date, and exercise or strike price.
There are several differences between futures and options on futures. For one, there are different obligations for buyers and sellers. Let’s take a deeper look at the difference between futures contracts and options on futures contracts.
With a futures contract, the buyer has the obligation to buy the specified asset at a particular future date. The seller must sell and deliver the asset on that future date, with the exception being that the holder’s position is closed before the date of expiration. A futures contract does not incur an initial cost, unlike options contracts. The size of the underlying position is generally larger. Gains are added to the futures account at the end of the trading day mark to market daily. This means that the value of the asset is recorded according to its current market price.
Options on futures contract
With the purchase of an option on futures, the buyer has the right, but is not obliged, to buy (or sell) the specified asset for a predetermined price. This right may be exercised at any time within the duration of the contract. The options contract must be purchased by paying the option premium. The size of the underlying position is generally smaller than for a futures contract. Gains can be made in the following ways:
- The exercise of the option when it is deep in-the-money
- Taking the opposite position as a hedging technique
- Holding the option until expiry and gaining the amount of increase between the asset price and the strike price
Interest Rate Options
An Interest rate option is a specific financial derivative contract whose value is based on interest rates. Its value is tied to an underlying interest rate, such as the yield on 10 year treasury notes.
Similar to equity options, there are two types of contracts: calls and puts. A call gives the bearer the right, but not the obligation, to benefit off a rise in interest rates. A put gives the bearer the right, but not the obligation, to profit from a decrease in interest rates.
The exchange of these interest rate derivatives are monitored and facilitated by a central exchange such as those operated by CME Group.