Options on futures , Strike Price vs Future Price and mark-to-market.

OK @karanv_10111‌ , first are you comparing a futures contract vs. an option on a futures contract (on the same underlying asset)? Or futures contract vs. option (on underlying asset)? I started to lose you in the last 2 sentences of your first paragraph.

On mark to market, yes, that means you are making $5 on your futures contract because you can buy the asset $5 cheaper than current market rates, so as of that day you’re $5 in the money. You declare this in your daily P&L to have the latest position of your trading portfolio. I don’t think you can adjust prices of contracts you’ve made, so I’m not sure what you mean by adjusting future prices.

Seems like a lot of confusion in your sentences here?

OK @karanv_10111‌ , let’s take this step by step and see if my explanation makes sense:

The buyer of an option on futures contract has the right (but not the obligation) to assume a particular futures position at a specified price (the strike price) any time before the option expires. If the option is exercised, the initial holder of the option would enter into the long side of the contract and would buy the underlying asset at the futures price.

Since in level 1 we are not given with the treatment to price futures.It took me a while to digest that strike price doesn’t become the future price to buy the underlying asset of the futures contract (Please correct me if I am wrong), it’s just the price at which we can buy the future contract.

In the case of futures options, the option strike price is the specified futures price at which the future is traded if the option is exercised. When you ‘buy’ a futures contract, there is no ‘price’ to pay per se, all you have to put upfront in terms of cash is the initial margin to cover the fluctuations in value of your contract. The strike price here for option futures is the futures price you secure when you decide to exercise your option.

E.g. I bought an option on coffee futures (to buy 1kg in 1 year’s time for $100). I paid the option premium upfront, in the 2nd month I decided to exercise my option because coffee pricing has increased to $120 per kg. The strike price of my option is the futures price of $100 per kg of coffee.

Your understanding is not wrong here, but in the case for futures, there’s nothing to ‘buy’ per se at inception of the futures contract, it’s a commitment to buy a certain commodity at a set price in the future. Margins are required to mark to market your position daily, that’s all.

Can somebody give an example as to when the underlying asset of the futures contract will have the spot price less than strike price of the option but the price of the futures contract will be more than the strike price of the option (to make the call option in the money )?

If the underlying asset of the futures contact have spot price less than strike price of the option (i.e. futures price), your futures is out of the money anyway (because underlying asset is cheaper to buy off market now). If your futures is out of the money, it does not make sense to exercise the option to ‘buy’ this futures position.

Also when we mark to market , I’ve heard that we adjust the future price to buy the asset of the futures contract , such that the present value of the future contract is zero again. Does it mean that if in a day’s movement in the price of the asset underlying the future contract goes 5$ above the future price to buy the asset of the futures contract in the contract , do we increase the increase the future price in the contract ?

In MTM, you don’t adjust futures price (the price you agree to buy an asset in a future date). Using your example above, with the underlying asset $5 higher than the futures price, your cash in the margin account would increase by $5 (assuming you bought 1 unit of futures).

OK I understand your source of confusion @karanv_10111‌ . You should have put the question upfront first next time 🙂

B immediately stood out as the correct answer to me, although C was put there to describe the case where it’s a call option on the underlying oil asset itself (rather than on futures). My question is, why didn’t you choose B?

I understand why C cause the confusion. The option price move along with the futures price and not the commodity price as you rightly understood. Although the futures price tracks the commodity price closely, they are not the same because futures pricing F = Spot x (1+r)^(t) [for discrete compounding and assuming no cash payout of the asset] . So this is what the explanation means, even though F moves closely with the underlying asset, F is likely to be higher because there is the risk free rate compounding effect incorporated in futures pricing. So in the extreme, say spot price of oil is $68.69 in the above example, futures price of oil is likely to be greater than $68.70 (which is the strike price of the futures option) as you need to multiply spot price with (1+r)^(t). In that case, it makes sense economically to exercise the option on oil futures, even though your spot price of oil is less than $68.70, because the futures price is > $68.70.

Hope that makes sense, I realise it’s lengthy!

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