Not so long ago, we published a piece on the blog introducing options on futures.
If you are looking to learn more about these types of derivatives, today's post should provide you with additional perspective.
As outlined in the introductory piece, options on futures aren't that different from traditional equity options. The big difference is of course the underlying - which is stock in the case of equity options, and futures for options on futures.
As a result, the "official" definition of options on futures also sounds fairly familiar, "an option on a futures contract gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a specific price on or before the option's expiration date."
Today we are moving past definitions and general overviews, and providing you with more practical information on futures options. For example, much like with options on equities, the "dollar and cents" price of an option on a future can be used to calculate the level of volatility that is "implied" by those dollar and cents values.
That means traders can use the implied volatility of futures options to make assessments on the relative "cheapness" or "richness" of those options, much like we do with traditional equity options. Likewise, we can use historical implied volatility data in options on futures to calculate Implied Volatility Rank (IVR), which can help us with such assessments.
Using crude oil futures options as an example, the graphic below illustrates how IVR can be calculated (as discussed in detail on a recent episode of Futures Measures):
As you can see in the above slide, IVR in crude oil appears to be elevated - and when IVR is above 50%, options traders often look for opportunities to get short premium. However, just like with equity options, there are additional considerations that traders usually take into account before executing on a given opportunity.
One factor that is usually considered is our outlook on the underlying. For example, if company ABC recently reported earnings, we might view the stock as range-bound in the near-term. Assessments like this also need to be established prior to selling premium in options on futures.
Looking at crude oil, we know that an IVR of 77% is generally perceived as “high,” but what other factors need to be considered regarding the current market landscape in the energy sector?
Even a brief scan of the financial headlines tells us that the sanctions planned for Iran are expected to significantly impact volatility in crude oil. That’s because the United States is asking some of its allies, as well as other worldwide consumers of Iranian oil, to boycott all purchases until Iran complies with demands made by the United States regarding its nuclear program.
Given that supply and demand in international crude markets are so tightly bound, one can see how a sudden drop in available global supply (i.e. removing Iranian production) might affect volatility in the underlying price. That means while IVR in crude oil may currently be elevated, any confidence that prices will remain “range-bound” in the foreseeable future appears more dubious.
Whether or not you view the current opportunity in crude oil as attractive, it’s important to remember there are many other futures products with associated options that can also be investigated for potential trading opportunities (gold, corn, bonds, etc…).
Additionally, if you do observe elevated levels of IVR for a specific options on futures product, you can also look at traditional equity options in the same sector to see if IVR in single stocks or ETFs is also trading at attractive levels. For example, looking at crude oil, you could pull up underlyings such as XOM, COP, or CVX and review the current IVR landscape in those names as well.
If you want to learn more about trading options on futures, we hope you’ll take the time to review the complete episode of Futures Measures focusing on IVR when your schedule allows. The following links may also be of interest:
As always, we welcome you to reach out with any comments or questions at your convenience. Just leave a message in the space below, or send a message to @tastytrade on Twitter or by emailing firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.