Futures Offer a Fast and Liquid Market

Options on futures. In some ways, they just about replicate the �Regular Stock Option Experience� but there are some really profitable ways to use futures if you know what to look for.

All options give you the right, but not the obligation, to buy (if calls) or sell (if puts) a specified quantity of some underlying instrument. An option on a stock or exchange-traded fund is quite simple in this regard. Say in mid-July you owned 1 August 135 call in SPY — the SPDR S&P 500 ETF (NYSE:SPY) that tracks the S&P 500 Index. The SPY was one-tenth the value of the S&P 500, so it would be trading around $135 if the index was near 1,350.

As a call option owner, you had the right (but not the obligation) to buy 100 shares of SPY at $135 sometime between mid-July and August expiration, which occurs at the close of the third Friday of August (Aug. 19 this year). Obviously if SPY closed above $135 on expiration, you would have exercised your right to buy SPY at $135, or you might sell your call. Given the market�s turmoil, however, you would have let your call expire without acting on it — eating your fee, but not wiping out your portfolio as the SPY crashed as low as $112 in August 2011.

A SPY call, or a call on anything for that matter, has a nice risk/reward backdrop. Your gains are theoretically boundless, whereas your losses are limited to the amount you paid for the call. This gets into two important distinctions of being long an option and being long the stock or ETF. First, options are cheaper than the underlying, giving the holder greater leverage. Second, the careful holder can get in and out of his position without taking ownership of the underlying security.

There are a number of trading vehicles linked to the S&P 500 Index because of its influence and popularity. One of the most active is CBOE S&P 500 Index Options (CBOE:SPX). The SPX is 10 times the price of the SPY. In many ways, SPY tracks SPX, and the two pretty much move exactly in line. If SPX moves up 10 points, SPY moves up one, and if SPX drops 10, SPY drops 1.

The Futures Advantage

But the options on SPX are very different from the options on SPY. They are futures options, and here�s the advantage of this product over standard options:

Instead of getting delivery of a stock (or basket of stocks in this case) you theoretically get delivery of the corresponding SPX future. Except the future itself simply cash settles. So if you had owned 1 SPX August 1350 Call, and SPX closed above $1,350 — say $1,355 — you would have collected the $5 cash difference. You need no extra money to settle the SPX call and you have no residual position once SPX expires.

In contrast, if you had exercised that SPY August 135 Call and taken delivery of SPY, you would have needed to put up the bucks to own the basket of stocks in the index, or more precisely, the percentage of stock that each makes up of the S&P 500 Index.

That might be a choice for an institutional investor, but few of the rest of us are interested in that. (Just to be clear, few SPY options traders decide to take delivery but instead sell their profitable long position and pocket the profits.)

One solid resource for futures products is the CME Group, the exchange that lists many of the most liquid futures products. It products include futures on metals, a slew of energy and oil products, foreign currencies and interest rates.

The Futures Negative

The pitfalls for retail investors around any cash-settled option like SPX often come back to settlement and expiration.

For instance, SPX options stop trading on the close of Thursday, then settle on the open of Friday, so you run the risk of a market move between Thursday’s close and Friday’s open. This can work against or for the investor, depending on the move, but you are left somewhat helpless overnight.

SPX futures and options settle on the opening “print” on expiration Friday. This is a calculated price based on the opening quote in each of the 500 stocks that comprise the index. This is another unpredictable number that can work for or against the investor.

To me, these are both outsized bets on a rather random outcome — one I would never make. I would close out before the options stop trading and let someone else roll the dice.

Testing the Waters

Keep in mind this article is just one narrow comparison of futures to “regular” options. Futures options come in many shapes and sizes and have all sorts of unique mechanisms. As a general rule, it comes down to the terms of the futures themselves.

If it�s gold and the future gives you delivery of a troy ounce of gold somewhere, so will the options on that future. These trading products are all pretty unique, and nowadays just about all have an ETF or ETN alternative, so use the product that fits your needs the best.

You may want to test the waters and compare futures options on say, gold, crude oil, and Treasury bonds to ETFs and ETNs like the SPDR Gold Trust (NYSE:GLD), the U.S. Oil Fund (NYSE:USO) and the iShares Barclays 20 Year Treasury Bond (NYSE:TLT).

This is a good opportunity to see how the game is played — and if it�s something that appeals to you, you can start opening your own contracts to meet your own investment style.

Follow Adam Warner on Twitter at @agwarner.