In earlier posts we covered futures markets. One of the important innovations of futures markets is options on futures. These contracts originated in the United States as a result of a regulatory structure that separated exchange-listed options and futures markets. The former are regulated by the Securities and Exchange Commission, and the latter are regulated by the Commodity Futures Trading Commission (CFTC). SEC regulations forbid the trading of options side by side with their underlying instruments. Options on stocks trade on one exchange, and the underlying trades on another or on Nasdaq.
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. The side-by-side trading of the option and its underlying futures made for excellent arbitrage linkages between these instruments. Moreover, some of the options on futures are designed to expire on the same day the underlying futures expires. Thus, the options on the futures are effectively options on the spot asset that underlies the futures.
A call option on a futures gives the holder the right to enter into a long futures contract at a fixed futures price. A put option on a futures gives the holder the right to enter into a short futures contract at a fixed futures price. The fixed futures price is, of course, the exercise price. Consider an option on the Eurodollar futures contract trading at the Chicago Mercantile Exchange. On 13 June of a particular year, an option expiring on 13 July was based on the July Eurodollar futures contract. That futures contract expires on 16 July, a few days after the option expires.” The call option with exercise price of 95.75 had a price of $4.60. The underlying futures price was 96.21. Recall that this price is the IMM index value, which means that the price is based on a discount rate of 100 – 96.21 = 3.79. The contract size is $1 million. The buyer of this call option on a futures would pay 0.046($1,000,000) = $46,000
and would obtain the right to buy the July futures contract at a price of 95.75. Thus, at that time, the option was in the money by 96.21 – 95.75 = 0.46 per $100 face value. Suppose that when the option expires, the futures price is 96.00. Then the holder of the call would exercise it and obtain a long futures position at a price of 95.75. The price of the underlying futures is 96.00, so the margin account is immediately marked to market with a credit of 0.25 or $625.” The party on the short side of the contract is immediately set up with a short futures contract at the price of 95.75. That party will be charged the $625 gain that the long made. If the option is a put, exercise of it establishes a short position. The exchange assigns the put writer a long futures position.