Options on futures can be a useful tool for hedging existing positions or selling premium in an underlying. One challenge with trading futures options is selecting the proper strike. Unlike equities which never expire or rollover, futures products do have expirations. Therefore, we need to make sure we use the correct expiration and strike when using futures options.

Just as we do when selecting equities, when trading futures we want to be certain the underlying asset itself is liquid. If a futures contract is not liquid, it is unlikely options for that contract will be liquid. Because there are multiple expiration months for futures contracts, we need to select the most liquid month.

Once we have identified which contract to trade, we then need to trade the correlated option expiration cycle. If September is identified as the most liquid month, we need to trade September options. Should we mistakenly trade in a further out month, we may run into problems as a result of contango.

Contango occurs when the further out month is more expensive than the near month contract. In the slide below, you can see how the price for October crude oil is more expensive than September. The steeper the contango or backwardation (when future month contracts are less expensive than current month), the more potentially problematic trading the wrong month may be.

Order entry is one element we can control which directly impacts our probability of being profitable. Key to that is being able to trade in liquid markets. At tastytrade, we avoid trading illiquid options, regardless of the product to which they are correlated. To determine liquidity, we use a combination of volume, open interest and the bid-ask spread differential.

Tom often discusses using short puts in both S&P futures (/ES) and bond futures (/ZB) to protect against short futures positions. Both products are very liquid and offer liquid options markets. Crude oil is another product in which we often use futures options. Liquidity is key to our style of trading regardless of whether we are discussing equities or futures.

Josh Fabian has been trading futures and derivatives for more than 25 years.

For more on this topic see:

Options Jive | Futures Options: Strike Selection: August 12, 2016