I’m on page 94 in the Derivatives and Alternatives book and it talks about Options on Futures. I can’t seem to figure out what the point is for them. If I buy an option on a future, I am buying the right to buy the future that will make me buy whatever asset at a set price in the future. Why not just buy an option on that asset and not dilly dally with a future? I’m probably missing something and someone knows this a little better. This might have something to do with it: “The futures exchanges got the idea that they could offer options in which the underlying is a futures contract; no such prohibitions for side-by-side trading existed under CFTC rules. As a result, the futures exchanges were able to add an attractive instrument to their product lines” Maybe my question should be: Why are these “attractive instruments”?
you are a corn grower. You expect to sell your produce 3 months or a year from now. You enter into a future. You are commited. You have a market at a price. End of part 1 of the story. Part 2 is you hedge your revenue. So to answer your first question: “buying an option on the asset” is you own a produce that you need to sell and not just searching fro opportunties. Also these are traded in different exchanges=no “side-by side” allowed. Hope this helps. I know it is silly at first
First, an option on an asset may be better than an option on a futures contract depending on what you are trying to do, liquidity, etc… For example, FX options are more liquid than options on FX futures and there are many situations in which an FX option would be a better derivative than an option on an FX futures contract. Next, there are lots of reasons that an option on a futures contract is better than an option on an underlier: a) The futures contract takes care of specifying quality, delivery, dates, etc. so the option contract doesn’t have to. b) The futures contract is much less cumbersome to deal with at option expiration than the underlier. I would much rather be given a long position in a corn futures contract than a grain silo receipt. That means I can exercise the option. Imagine the pricing issue if everyone knew that I didn’t want to exercise the option because I have no need for corn. Since you can close out the futures contract (usually for no cost) at option exercise, the option on a futures contract is nearly a cash-settled option. c) An option on a futures contract may give you valuable delivery options. For instance, a bond futures put when exercised then gives you a package of valuable bond delivery options. A bond put would just give you the right to sell a bond. d) You can more easily price futures options because the underlier is clearly priced. How would you price an option on corn without using the futures contract? Note that forward corn is not easily priced so an option on it is even tougher. e) There is no counterparty risk in a futures option and there would be in almost all asset options. “Anybody” can buy or sell futures options. You can buy and sell them in your pa. Try selling a corn put in your pa. A futures option is a really clean derivative - much cleaner than an option on the underlier (usually). I know it sounds more complicated though.