What are Futures Options?

Futures options are tools that investors use to make money on anticipated changes in commodity prices. Commodities are items that are traded on an exchange and are the same no matter what their source is. Futures options, therefore, are investment securities that provide their owners with the right to buy commodities futures like gold, paper, or a foreign currency at a specified price.

An important distinction must be made between a futures option and a futures contract. A futures option is a financial instrument that gives an investor the right to purchase a futures contract for a particular commodity. By contrast, a futures contract is a contractual obligation to purchase the commodity itself, in a specific quantity, for a specific price and at a certain time.

Investors who want to purchase futures options must first determine whether they believe the underlying commodity will rise or fall in price over a certain period of time. If an investor believes the price will rise, he or she could purchase a call option, thereby giving him or her the right to purchase at a certain price at any time before the option expires. An investor who believes a commodity's futures price will fall can purchase a put option, giving him or her the right to sell at a certain price during the period of the option. During that time, if it would be advantageous to exercise the option, the investor is said to be "in the money."

The price an investor pays for the futures option at the time of purchase is called the premium price. This amount varies depending on the length of the option and the amount of risk an investor is taking. In cases where there is little risk that the commodity price will fluctuate over the period of the option, the premium price is higher; the price moves lower as the amount of risk increases.

Strike price is the price at which the investor may purchase the underlying futures contract. It is worth noting that many investors, even professionals, never actually purchase futures contracts. Instead, they simply buy and sell the less-risky futures options.

An investor who wishes to purchase a futures option will usually work through a broker or brokerage firm. This individual or company is the bridge between the buyer of a commodity and the seller. When an investor purchases a futures option, he pays a commission to the broker, who is then responsible for executing, or completing, the trade.