Despite the fact that you are trading derivatives on derivatives, futures options are actually a low-risk, low-cost way to get into the futures market. You can buy an option on a futures contract for a fraction of the cost of buying the futures contract, and because options give you the right but not the obligation to purchase the underlying instrument at the strike price, your loss is capped to the premium you paid for the option if the trade goes against you.
Futures are highly leveraged derivatives, and the futures market is extremely volatile, traded mostly as an instrument of speculators or hedgers. When you buy a futures contract, you are obligated to complete the transaction on the execution date, although in most cases, contracts are traded before expiry.
The mechanics of futures options are the same as any other type of options. If you are bullish on the underlying instrument, gold, for example, you would buy a call option; if you were bearish, you’d buy a put option. Here’s where options on futures trading gets attractive for retail traders: A gold futures contract might require an initial margin of $5,000, which would control 100 ounces of gold, or about $135,000 at current prices. And depending on where the price goes, you may need to make ongoing margin deposits if the trade goes against you.
An option on the very same gold futures contract, on the other hand, might have a premium of $5, or $500 for the contract of 100 ounces, plus commissions, of course. It is much easier to get into trading options than it is to get into the futures market, and the risk is much lower since there is a hard limit on your losses compared to a virtually unlimited loss potential with futures.
You can also use futures options to generate income if you happen to own the underlying futures contracts. The writer of an options contract pockets the premium and can close the position at any time to lock in profits or limit the loss.
If you want to trade options on futures, you need a brokerage account approved for options and futures. Options and futures trade on the CME and the Chicago Board Options Exchange, which is where you can find quotes. Contracts are available on a wide range of underlying assets, including commodities, major indices, ETFs, forex, bonds, and even individual stocks.