Options on Index Futures

III. Secrets of Trading: Section 6 of 6

Options on index futures add another dimension to the broad market coverage offered by futures - limited risk.

The buyer of a call or put option has unlimited profit potential with the risk limited to the price (called the "premium") paid for the option.

The option seller, on the other hand, accepts potentially unlimited risk in return for the option premium at the time of the sale. (Because they're subject to unlimited risk, option sellers have performance bond requirements as well; option buyers do not.)

For instance, an S&P 500 call option gives the buyer (also known as the holder) the right, but not the obligation, to buy one S&P 500 futures contract at a specific price - the strike or exercise price.

An S&P 500 put option gives the buyer the right, but not the obligation, to sell one S&P 500 futures contract. These rights can be exercised at the option buyer's discretion at any time before expiration. Or, the option itself can be re-sold (offset) on the Exchange. To offset a call purchase, you would sell the same call (i.e., same expiration, same strike price); to offset a put purchase, you would sell the same put.

The key phrase for the option buyer is right, not obligation. The option writer or seller, on the other hand, is obligated to perform if the buyer chooses to exercise the option. When a holder exercises, a writer of the same option is randomly selected from all those who currently hold open short option positions. That assigned writer receives a futures position (short for a call, long for a put) at the strike, or exercise, price. The seller accepts the unlimited risk of being assigned a futures position if and when the buyer exercises.

At expiration, open option positions may be automatically exercised and assigned if the options are in-the-money or if they have intrinsic value. Your broker can give you specific information for your circumstances.

The availability of options with differing expiration dates and strike prices provides option buyers and sellers alike with a wide range of trading and hedging alternatives. For example, options may be used independently, along with cash market portfolios or in combination with other futures and options positions.