I have a fundamental confusion regarding the option on futures contracts. I understand that a call option on futures gives the call holder the right to buy the futures contract at the strike price. However, when we exercise the option when it is in the money(e.g. the future’s price is 120, the underlying stock price is 121, the option’s strike price is 110). Do we pay $110 to the option writer to obtain a future contract with a price of 120? That doesn’t make sense since the future contract’s value is practically 0. Why would I pay 110 to buy a futures contract that gives me an obligation to buy the underlying stock at 120 at expiration? So I will eventually buy a single stock with 110 + 120 = $230?
On 15 Jan you buy a 1-month call option on a 6-month futures contract on XYZ stock. The strike price on the option is 110, and the premium is 5.85. So you pay the option writer 5.85 for the option.
On 15 Feb, the spot price of XYZ is 121, and the 6-month forward (futures) price is, say, 122.50. You exercise the option and enter into the long position in a 6-month forward contract on XYZ stock with a strike price of 110; the option writer takes the short position in that forward contract. On 15 Aug, the option writer delivers one share of XYZ stock to you and you pay him 110.
I suspect that instead of waiting 6 months to settle the forward contract, you can probably settle it in cash on 15 Feb: you would receive the present value of 12.50 (= 122.50 − 110), discounted for 6 months at the 6-month risk-free rate.
Thanks, Magician! I think I know what I am missing here. In the book, they say during the execution, the option holder “buys” the underlying futures contract at the strike price, but in essence, what happens is they convert their option into a future contract with the future price = strike price of the option. So the option holder does not pay the future contract anything when the option is exercised(instead due to the mark-to-market of futures, the seller of the future has to pay the buyer cash equals the (current future price - strike price) and deliver a future contract with its price equals the market future price), only when the futures contract expires, the buying party pays the future price to buy the underlying.
I spend a lot of time figuring this out… the original word “buy at strike price” is really misleading. Really hope this could help more people with similar confusion!
Welcome to the world of sloppy language used by finance types.
The expression “buy a futures contract” means “enter into the long position in a futures contract”. Analogously, “sell a futures contract” means “enter into the short position in a futures contract”.
Note that finance types’ sloppy language is not confined to “buying” and “selling” futures contracts. Beware!
Options on futures works different relative to options on forwards. In the example you quoted, you would essentially get a cash payment of $10 (the difference between the FP and the strike price). Alternatively, you can exercise and obtain a long position in a futures contract with a margin balance of $10.
Because of mark-to-market feature of a futures contract, a long position that is in the money simply gets paid at daily settlement (and in effect a new contract is initiated with a new futures price).
So if I exercise at 110 I still have to pay for it, let’s say I have 1 option on future with nominal USD 100k. What do I pay actually?