While trading options what should be a practical reference point — spot or futures?

Options are derivatives of the underlying but are tracking spot prices as a reference point practical? In the real world, a more practical approach would be to track futures as a reference point for trading options. Let us understand this in detail.

Dividends

Dividends are input to the option pricing models and since it is discrete it will need to be accounted for only in the expiries where it can create an impact. On the ex-date, the stock will fall with the value of the dividend and a no-arbitrage theory will hold true.

If we are pricing options on the spot, we will need to account for the possible inter expiry dividend else there will be a jump. But we do not see the jump in option prices when dividends are declared due to the fact that, the market discounts them in advance.

Futures prices will adjust for the dividends in advance and will trade at a discount, this can act as a true reference point for options as the option prices will also discount it in advance.

This does not end here. It gets more complicated when the market expects a dividend that is not yet declared. Unless the dividend is declared, the value is not known but the futures market will account for a market dividend expectation and will trade at discount to adjust the expectation, and so will the option prices. Hence, tracking the futures prices as an underlying is more realistic.

Interest Rates

Interest rates are dynamic and can keep changing even during the day. Since interest rates are input to the option pricing models, it becomes essential to account for them. Futures already accounts for interest rates and if we account for futures as an underlying, the complex task of getting real-time interest rates goes away.

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