What it means
A futures contract is an agreement to buy or sell something at a fixed price on a future date, and it carries a binding obligation. An option on a futures contract adds choice.
The buyer pays a premium for the right to enter the futures contract at the strike price, and may let the option lapse if that is not worthwhile. If the holder of a call option exercises, they receive a long futures position at the strike price.
If the holder of a put exercises, they receive a short futures position at the strike price. Often the holder never takes the futures position at all but sells the option, or closes out the resulting position straight away to take the profit.
Farmers, airlines, miners and manufacturers use these options to set a floor or ceiling on prices. A grower might buy puts to guarantee a minimum price for a crop, while an airline might buy calls to cap fuel costs.
In both cases the maximum loss is the premium paid, which is easier to budget for than the open-ended risk of a futures contract. There are practical points to understand.
Futures contracts have a standard size and expiry, so the option inherits those features, and a business must match its exposure to the contract size as closely as possible. The premium is paid upfront, and options sold rather than bought bring the obligation to post margin.
Options on futures also differ from options on the physical asset. Their value is driven by the futures price, which already includes the cost of carrying the asset to the future date.
This makes them popular for commodities and financial indices where holding the physical asset would be awkward.
In practice
Real-world examples.
Example
A wheat farmer buys put options on wheat futures to guarantee a minimum selling price for the harvest. If prices fall, the puts gain value and offset the lower sale price. If prices rise, she sells her crop at the higher price and loses only the premium.
Example
A snack manufacturer buys call options on cocoa futures to cap its ingredient costs. The finance team records the premium as a cost of hedging and spreads it over the period covered.
Example
An investment fund buys put options on stock index futures to protect a portfolio ahead of a risky period. The fund prefers options to selling futures because it does not want to give up gains if the market rises.
Formula
Calculation
Intrinsic value of a call = maximum of (futures price - strike price, 0) x contract size
Profit on a long call = intrinsic value at the time of sale or exercise - premium paid
An oil buyer purchases a call option on a futures contract of 1,000 barrels, with a strike of $70 per barrel, paying a premium of $6.80 per barrel. The total premium = 6.80 x 1,000 = $6,800. Later the futures price rises to $80, so the intrinsic value = (80 - 70) x 1,000 = $10,000. Profit = 10,000 - 6,800 = $3,200. If the futures price had stayed below $70, the option would expire worthless and the loss would be limited to the $6,800 premium.Case study
Seen in the real world.
Sunfield Mills is a fictional flour producer that buys wheat on a rolling basis and sells flour on fixed-price contracts. The finance director feared a sharp rise in wheat prices that would squeeze margins.
She bought call options on wheat futures covering the next six months of purchases, spending $90,000 on premiums. Wheat prices later rose sharply, and the options paid out $210,000, which offset most of the higher cost of grain.
In this illustrative story the hedge worked as insurance. The finance director noted that, had prices fallen, the company would have lost only the $90,000 premium while still enjoying cheaper wheat, which is the advantage of using options instead of futures.
Watch out
Common mistakes.
- Confusing options on futures with futures themselves, when only the option gives the right without the obligation.
- Forgetting the premium, which is paid upfront and is lost entirely if the option expires worthless.
- Ignoring contract size and expiry, so the hedge covers the wrong quantity or the wrong period.
Questions
People also ask.
What happens when a call option on a futures contract is exercised?
The holder receives a long futures position at the strike price, which is then marked to market like any other futures position.
Why use options instead of futures to hedge?
Options protect against an adverse price move while keeping the benefit of a favourable one, at the cost of the premium.
Are options on futures only for commodities?
No, they also exist on interest rates, currencies and stock indices.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%