Future Options are exactly what their name implies – an option on a futures contract.
Futures and Options – Related Derivatives
Futures and options are both derivatives – meaning a security whose value solely depends on the value of the underlying asset.
- A future derives its value from the commodities or currencies which it represents
- An option derives its value from the underlying stock
Futures and options were indistinguishable for most of recorded history – the first example of a derivative trade is from Plato, commenting on an investor who purchased the rights to use olive presses before a harvest, then resold the rights afterwards.
In the 19th century, futures became standardized and regulated in the United States, as they were an essential part of the agriculture market (which is why Futures are traded out of the Chicago Mercantile Exchange in the Midwest, as opposed to New York). The value of futures is both to the buyers and sellers of the underlying commodity – the commodity producers know they will get at least a certain price for their output (protecting against a market surplus and low prices), while the futures traders are protected against market shortages and high prices.
Options were standardized later, in the fallout of the stock crash and the Great Depression. Options contracts hold the same “insurance” value as futures, helping protect investors against price swings.
The Rise of Future Options
Future options themselves arose much later, in the 1980’s and 1990’s. These are derivatives of derivatives, meaning they are two steps removed from the underlying asset.
Future options exist because the certainty value of a future contract has risen greatly for the traders who buy futures. For example, American Airlines ( AA) tends to buy many futures contracts for oil to protect against price shocks in airplane fuel, which severely impacts the profitability of each flight. Since stability of prices is important, but they also do not want to be locked into buying the underlying asset well above the market price, they may instead buy future options, which give the right to buy a future at a later date, but do not require it.
This relationship means that future options typically have very low volume in the real markets – only very large market players need the kind of price insurance that requires a future option. This means most future options typically do trade, but at very low volume.