How Futures Options Preserve Choice While Futures Fix a Price
Summary
The document explains why a trader who wants downside protection with the ability to benefit from rising prices may choose an option on a futures contract instead of entering a futures position later. A futures contract fixes exposure to a market price and creates an obligation; it does not let the trader choose a previously desired entry price after seeing how the market moved. The ability to decide later whether to enter at a preset price is the optionality being purchased.
The response compares futures to options as hedging tools: futures neutralize price risk but give up favorable moves, while a put option can protect against adverse moves and leave gains from favorable ones available, in exchange for an option premium. It also explains that futures are often the liquid price-discovery instruments for commodities and other assets, making options on futures practical even when the underlying spot market is hard to trade. The discussion is conceptual and omits premium valuation, margin details beyond a brief mention, and the specifics of matching the hedge to a real position.
Key ideas
- A futures contract fixes a market-based price exposure and obligates the holder to the contract.
- A trader cannot wait to see the future price and then choose to enter a futures contract at an earlier preset price without paying for optionality.
- A put option on futures can limit losses from falling prices while preserving upside participation.
- Futures options are useful where futures provide more liquid price discovery than the underlying spot market.
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Full text
# Buying an Option on Futures or entering a Futures contract # Buying an Option on Futures or entering a Futures contract Let's say I want to hedge my current position using a futures or future options. What is the use of buying a future option if I can enter into the futures contract at zero cost(at any time before the last trading day of futures contract)? example: Lets say at time 0, commodity's price is 100\$ per unit. I would like to sell the commodity at time 2 for at least 105\$. If I go short on a futures contract with strike 105\$, I will only be able to sell at 105$ even if the price is more than 105\$(lets say 110\$). If I go long on put future option with option maturity at time 1, I have an option at time 1 to go short futures contract with strike 105\$. This will be advantageous if the price has gone down(lets say 90\$). If the price has increased, I will not exercise the option and sell the commodity in the open market. My question is: Can't I get into a futures contract at time 1 with strike 105\$? Since I know at time 1, if the price has fallen to 90$ or rose to 110\$, I will get to decide if I want to get into the contract or not. ## Answer by AKdemy (score 0) https://quant.stackexchange.com/a/64111 "Since I know at time 1, if the price has fallen to 90 or rose to 110, I will get to decide if I want to get into the contract or not." Assuming you can enter at any price you want is flawed (unless you think of an option). You ARE in the futures contract (or not). If you enter into a future, that is it (ignoring that you can get out of it whenever the market is open). If the price moves against you, you would have been better off if you had not entered into it in the first place. A future neutralizes risk by fixing the price but it is an obligation. A key aspect of hedging with futures is that you will never know if it will be better than the outcome without hedging. If you could simply say at some time t in the future that you want to enter at 105, than you actually own an option. If not, the future price will be determined by the market and you have zero choice what that will be. That is also the reason you have zero cost (well kind of, as you also have to post margin). The price will be such that it is "fair" and no one is better off, hence no one needs to be compensated. An option on the other hand is (like) insurance. It protects against adverse events (price movements) while allowing one to benefit from favorable price movements (where your future will make you wish you wouldn't have entered it). However, I think there is an interesting side aspect of this question. Why do you actually enter an option on the future and not the underlying? Do you know the price of WTI? Probably yes. Do you know Alaska North Slope, Canada Select, Light Louisiana Sweet or Gulf Deepwater Sour? Probably not. If you google WTI price, have a look at the results. These are all futures prices, as they play the primary role of price discovery (nowadays). That is also the price you will have to take at time t (and not your assumed 105). In many cases (especially for commodities, but also for treasury bonds etc.), futures are much more liquid and easier to trade than the underlying itself. Also, exercising the option on a future does not lead to delivery of the underlying. OK, you could have cash settled options on spot prices, but the standardization and liquidity is the real point here. The exchanges usually do not have spot trading for commodities (and in some cases, how do you actually trade the S&P500 Index? E-Mini's are very liquid on the other hand). Since (at least traditionally) there was a lot of PIT trading, and futures and options traded side by side, trading, arbitraging and hedging was a lot easier in futures and options. Long story short, if you want to know today what price you can enter into your future at some time t, you need an option.
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