Futures Options Trading – Pros and Cons

Futures Options Trading – Pros and Cons
| Gery Nagy, guest writer Gery Nagy, guest writer

A few years ago, I switched almost entirely to the market of futures options. I used to trade a lot with stock options and ETF options, but today I rarely do that. Let's see why!

But before explaining why I like futures options, it is worth clarifying what futures trading means, as this topic is totally obscure even for many advanced traders.

Futures Options Trading Explained

A futures transaction is a transaction that is not fulfilled immediately but on a future date. A multitude of companies open futures contracts every day when they sell their products at a predetermined price and date or they buy something. The most common example is when a car manufacturer undertakes to deliver 100 cars in a month at a specified price. This is a futures transaction as well. The stock exchange futures are the same, but they are connected to financial products. Basically, we distinguish exchange traded and OTC futures markets. Exchange traded futures are called futures, and OTC transactions are called forwards. In the following, I will talk about futures, as I trade with their options. They are called futures options or you can read about them as options on futures.

The basic unit of futures is a contract, which can be up to 1,000 barrels of oil or one ton of wheat. As the fulfillment will be in the future, you do not have to pay the total counter value immediately, it is enough to have a fraction of it. This is called initial margin. If the price moves against me in the meantime, a maintenance margin is charged for the transaction in addition to the initial margin. In case of counter-directional movement, the margin requirement continues to grow, which may lead to liquidation in case of a badly chosen position size. Therefore, it is important to be thoroughly familiar with the particular product, its margin requirements and other features and of course to choose the right position size relative to the account.

Due to the leverage, these transactions have high potential risk, but also high yield.

The Advantages of Trading Futures and Futures Options

One main advantage for trading futures is the high leverage, by which the rate of return on capital can be significantly increased. Obviously, it is associated with a higher risk, so absolute beginners are recommended to trade these products only after serious practicing and testing. Since the option is a leveraged product itself, the combination of the two can achieve a very nice return on investment within the given market conditions.

What I mean by testing is to have a demo account and test your ideas before you commit your hard earned money to the live market. You need to be familiar with the specific margin requirements and leverage before you can trade them live. I am not a big fan of trading on a demo for too long because it doesn’t have the same psychology as the real one, but for being familiar with the particular product, it is necessary.

The other reason is that it is open nonstop (with a few exceptions) just like the Forex market, so an option position can be converted any time. Obviously, it is best when the US market is open, because the market can become rather illiquid in closed periods (wide bid/ask spread).

What is the difference between futures, ETFs or stocks?

The biggest differences are: position size, margin requirements and leverage. Let’s compare a simple stock or ETF purchase to a futures contract.

Leverage and margin requirement

If you buy 100 shares of Apple at $145 you have the nominal value of 100x145 which is $14,500. Since most brokerage firms provide 1 to 2 leverage you only have to put up half of this amount as overnight margin requirement. It means only $7,250 of your buying power will be allocated to this trade. If you are trading Apple with CFD, you can have much higher leverage than that but this depends on the brokerage firm you choose to trade with. I don’t like CFDs because they are not as regulated as stocks and they are not the stock itself. If you want to invest in a stock, I would do it directly buying the stock not the CFD. Holding onto a stock for long term doesn’t have any significant additional cost. Holding onto a CFD might have higher costs because of higher leverage and interest you have to pay on the margin.

What happens if AAPL moves up 10%? You will gain $1,450 based on your $7,250 initial allocated capital. This is a 20% return on allocated capital.

Let's look at an example for the current leverage of oil (one of my favorite products). At present, the price of crude oil (/CLQ7) for August 2017 is 43.26, its margin requirement at Interactive Brokers is approx. $5,000. As one contract means 1,000 barrels, the nominal value of the actual physical product is $43,260. However, its margin requirement is only $5,000. This means that there's almost 12x leverage at the current price level. Such leverage cannot be achieved with simple stock trading, not even with ETFs. You do not need to pay that $43,260 to trade with oil. You only need to put up around $5,000 in margin.

What if /CL rises 10%? You will have a profit of $4,326 which is almost as much as your initial $5,000 margin requirement. Do you see the difference?

With stock or ETF trading you could gain 20% by a 10% move in the stock however in case of futures trading you can almost make 100%. This is obviously a double edge sword because leverage can be very good if the market goes in your direction but could decimate a trading account if it goes against you.

It all comes back to position sizing and management. If you know what you are doing, futures options are a much more lucrative business to be in.

Position sizing

Let’s talk about the positions sizes. When you trade ETF’s or stocks, you can buy as small as 1 share of AAPL which is $145 right now. So you can trade really small.

However if you try to buy 1 contract of /CL you have to put up around $5,000. This is a huge difference! So futures trading are absolutely not for beginners with small trading accounts.

If you compare futures options to stock or ETF options the difference can be even bigger than above. One of this difference is what I call high credit/margin ratio, i.e. the rate of return on the margin is much higher in case of futures options selling than in case of ETFs or index products. For comparison, here is an example for range trading in case of S&P500 ETF (SPY) and futures (/ES). Range trading means that you are expecting the underlying to stay in a range until options expiration.

SPY vs. /ES, A Non-Directional Option Trading Example

SPY is the ETF of S&P500 index and /ES is its futures contract. Both trade the same underlying but with different product specifications. In the example below I compare two scenarios where I would like to trade in a nondirectional fashion. Nondirectional trading means that you don’t have an idea where the underlying might go, but you try to trade the probability of a channel for certain days. This is accomplished by options selling.

I examine a 30-day channel with a 90% probability for both products. It means that I establish a positions which is profitable when the underlying stays in a 90% probability range or channel. 90% is a pretty wide channel / range.

SPY (ETF options): 1 contract S&P 500 ETF option pays $40 at expiration, if it stays in the range; for $3,500 initial deposit. This is 1.1% return.

The chart below shows you a range with 90% probability for SPY if you sell the 30 days options. The two strikes are 226 and 251.

 

futures-options-trading-spy


/ES (futures options): 1 contract E-mini S&P 500 Futures option pays $190 at maturity if it stays in the range, for $4,200 initial deposit. This is 4.5% return.

Below is the same chart for /ES. The strikes are 2250 and 2500.

 

futures-options-trading-es



I think, you can see the difference between the two options at first glance. This is what I call a credit/margin ratio: the rate of premium received compared to the initial margin. If you watch closely you can also see that the channel is skewed to the downside. This is because Put options have much higher premium than Call options, that is why the channel is not symmetric.

Please stop for a moment and think about it. In the example above I had the same trading bias, but I traded with different products. The return is much higher in the case of futures options. The risk is also higher because of higher notional value and leverage. But if you know how to trade them futures options is much better to trade with than stock of ETF options!

That's the main reason I prefer to trade futures options lately.

Who is futures options trading for?

As I stated earlier futures options trading is not for beginners. Mostly because you have to trade with higher margins, nominal values and leverage. If you are not a seasoned trader, margin and leverage can hurt you very badly.

However, if you are already experienced, switching to futures options is the way to go. You can have much better return on your allocated capital, you can have more control over the underlying since it moves all day long during weekdays, etc.

By the way who is options trading for?

Maybe we need to clarify first who is NOT suitable for Options Trading

  • Daytraders are better off avoiding this market, options are not daytrading instruments,
  • if you are not sufficiently committed to continuous learning and development, I also do not recommend this market, because it is the most difficult of all the stock market products (but one of the most profitable instruments).

Now, let's see who is options market for:

  • If you have only 1-2 hours per day for trading, it is ideal for you, as options can be best used for swing strategies.
  • If you do not have tens of thousands of dollars to buy stocks, it is also ideal for you, because the suggested minimum capital to get started is $ 5,000.
  • if you are fed up with having to predict where the market will go - because options strategies make it possible to earn money without direction (trading strong levels).
  • if you are fed up with the fact that you never place the stop to the right level – namely because we do not use stop in options trading, yet we manage risk much better and control is totally in our hands.
  • The most important of all, is that the risk can be pre-defined without stop orders and you do not have to sit in front of the charts all day. It is enough if you analyse the market after work and you can make money in max. two hours per day. Obviously, you need more time at the learning stage, but if you get some routine in the world of options, 1-2 hours a day will be enough for it …

Where to trade futures options?

I personally trade at Interactive Brokers. No matter where you trade you have to take the counterparty risk into consideration. I have been trading at IB since 2011. I have never had any problems in terms of execution or settlement. They are pretty reliable and low cost firm. They sometimes call themselves discount brokerage, The only downside I can think of is their customer service chat. Sometimes you bump into people who have no idea what they are talking about, but at least they kindly try to help you. I would choose a brokerage firm with many years already in the business, high protection for customer accounts and of course with valid license in a regulated country and market. I would never wire my money to offshore brokerage firms or unregulated entities.

I think the best market for futures options trading is the US market and you can find many reliable and big names there to choose from as your brokerage partner.

Also, you need a partner where futures options are allowed. Not all of them allow to trade futures options. There are many firms for example where futures option selling is not allowed. If you are considering nondirectional trading with futures options, you need to have them enabled. Here is a list of firms where you can trade futures options:

This article was written by one of our guest blogger, Gery Nagy. He is a professional options trader who has been trading (futures) options since 2005. You can read more about his thoughts and idea on his website at www.optionsrules.com.

Bottom line

To sum it up: futures options trading is the most lucrative type of options trading that you can find in the universe of finance today. But you have to be prepared to reap the rewards of this game. If you are only a beginner, you need to take your baby steps first and start with stock or ETF options trading which has lower leverage and lower risks. 


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