In this article, I will look at the E-minis, which are a derivative of the S&P Cash Index, and at the options on the E-minis, which would in turn be a derivative of the derivative. I will explain how they each work in isolation, which will help demystify how the other one functions as well.

Hence, let me start with the Dictionary.com definition of derivatives and then proceed to the explanation of the difference between the two.

The exact definition reads: de-riv-a-tive: adjective 1. Derived, 2. Not original, secondary... 7. A financial contract whose value derives from the value of underlying stocks, bonds, currencies, commodities, etc.

Basically, it is a secondary value that has been created from an original value. So if we think about options and their premium, it is the same thing. The value of option premium was created based on the current value of the underlying. Now that we have options on the futures, the definition of the option does not change, but the futures themselves are also a secondary product, which derive their value from the underlying. Let me simplify this; the underlying is the S&P 500 cash index, currently (at the time of writing) trading at 1122. The E-mini Futures Contract ES (Dec 2010) is trading at 1113, and they derive their value from the S&P cash index. There are options listed on the ES with various expiration dates. For instance, there are options for the ES in the month of Oct 2010, Nov 2010, Dec 2010, Jan 2011, March 2011, & June 2011.

In terms of liquidity, the options on the ES are not as often traded as the E-mini contracts. What makes the E-minis and options similar is that they both derive their value from their original underlying. In the case of the E-minis, their value is created based off the cash index. In the case of the option contracts on the E-minis, their value is based off the E-mini, which in turn is already a secondary product; hence, the name derivatives of derivatives.

Having provided the working definition, I will proceed in explaining the difference in their leverage. There could be two separate discussions of leverage. The first one is concerned with how much a trader could win or lose for one handle move of the underlying. The second one is concerned with the "maintenance," or more specifically, how much does one need to have in order to hold either one E-mini contract or one option contract.

In order to make things simple, I will use the ES for my example. The ES are the E-mini S&P 500 contracts. Each of the E-minis has a different multiplier, so I will just stick to the most popular one and also the most liquid one of all the E-minis. After explaining how the leverage works for the ES E-mini, I will proceed by examining how much the individual option contracts on the ES E-mini would make or lose for a single handle move either up or down. The summary of the difference will become evident.

Starting with the leverage of the ES E-mini, I have created a chart that breaks down the info into ticks, fractions, decimal, and the value in US dollars.

Basically for every tick, which is a quarter point, our ES E-mini contract is making or losing the amount of $12.50, and for a whole point move, the E-mini is making or losing $50.

For the first ES point move in our forecasted direction, our ES E-mini contract makes $50, which means that if we divide our reward with our risk/maintenance of $5,625 (50/5,625), then the percentage of our return is very small, 0.008 with 8 repeating.

The next figure shows the cost of the call option premium of the ES for the month of October 2010. The option contract selected is the October ES 1000 call, with a delta of 0.90 cents, which means that if the underlying moves a whole point, the October 1000 ES call makes 90% of that move. While the ES is at 1113, the option Bid was quoted at 116 and Ask at 118, leaving us with the logical conclusion that the midpoint is 117, meaning that it would cost us $11,700 to enter that position (unless you have 50% only margin, then it would be half that.) The reason why the October 1000 ES call does NOT have premium at 113, which would be logical (1000 call plus 113 equals the current ES level of 1113), is because of time value. By selecting the deep ITM (in-the-money) call, the exposure to time decay is reduced, yet the October 1000 ES call still has time value of $4.00, while its intrinsic value is, as mentioned above, at 113.

For the first ES point in our forecasted direction, our Oct ES 1000 call would make only $90, which means that if we divide our reward with our risk (90/11,700), then the percentage of our return is very small 0.00769.

From this example, it can be seen that it is the Delta of the ES option contract that determines the possible profit and loss.

To recap, each ES E-mini point has a multiplier of $50, and if the S&P futures contract moves up or down one point (handle), the E-mini either gains or loses $50. The maintenance of holding one ES E-mini contract is $5,625, and as long as the trader has that amount in his or her account, the trade can be executed. A single futures contract actually controls approximately $50,000, depending on where the underlying is currently trading.

More specifically, if the S&P 500 cash index is currently trading at 1122, and the E-mini multiplier is $50, then one single ES E-mini contract controls (1122 times 50) $56,100 dollars of value; so technically speaking, the maintenance ($5,625) is only about 1/10 of the value.

On a final side note about the option contracts, if a trader either shorts or goes long on a single S&P (futures) option contract, and if it is exercised, then the contract converts into one E-mini futures contract.

In conclusion, in this article, I have looked at the E-minis, which are secondary to the S&P Cash Index, and at the options on the E-minis, which would in turn be the derivative of the derivative. Options and futures aren't exactly the same, but they are closely related. Understanding how one works in isolation can greatly help at demystifying how the other one functions as well. The word that I like to use to explain the relationship of futures and options is "cousin." Have green trading.