The price of a futures options is created by market participants, who trade these types of financial products. Many investors use futures options pricing models to help them gauge an estimated value of specific options. Options pricing models require a number of market variables that are used as inputs to calculate a fair value for options on futures.
A futures security is a contract between two people to purchase and sell an asset at some time in the future. The assets can be commodities such as crude oil or soybeans, or financial instruments such as Treasury bills or equity indexes. Futures create an obligation to purchase or sell an asset at some time in the future, and they are traded and cleared through futures exchanges such as the Chicago Mercantile Exchange.
Options on futures are the right -- but not the obligation -- to purchase a futures contract at a specific date in the future. The strike price is the price at which the buyer of a call option can purchase a futures contract. The expiration date is the date when the option expires. When a buyer of a call option exchanges the option for the futures contract, the process is referred to as exercising the option.
Calculating the Value of a Futures Options
During trading hours, market participants create a fair value for an option on a futures contract buy quoting prices at which they will purchase or sell specific options. Investors who participate in this type of activity will estimate the price of an option buy calculating its value using an option pricing model. There are a number of reputable permutations to pricing models, but the industry standard is the Black Scholes options pricing model. Option pricing models will produce a value, given a number of variables that are used as inputs into the model.
Option Pricing Inputs
The most important variable used to calculate the price of an option is the implied volatility of a futures market. The model is based on how much market participants believe a futures contract will move during a specific period in the future. The more people who believe a market will gyrate, the more expensive the price of the option. There are other inputs used to price an option, such as the strike price, the current price, interest rates and the expiration date.
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