Futures and options are similar in that they are both derivative contracts between a buyer and seller to trade an asset at a certain price, on or before a certain date. Investors can use these instruments to hedge against risk and potentially earn profits — but options and futures function quite differently.
Options are derivatives contracts that give buyers the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) an asset at a specified price within a certain period of time.
Futures are another type of contract in which buyers and sellers are obligated to trade a specific asset on a certain future date, unless the asset holder closes their position prior to the contract’s expiration. A futures contract consists of a long side and a short side, where the short side is obligated to make delivery of the underlying asset, and the long side is obligated to take it.
Both options and futures typically employ some form of financial leverage or margin, amplifying gains and losses, creating a greater level of risk.
|Buyer is obliged to take possession of the underlying asset, or make a trade to close out the contract.||Buyer has the right, but not the obligation, to buy or sell a certain asset at a specific price.|
|Futures typically involve taking much larger positions, which can involve more risk.||Options may be less risky because the investor is not obliged to acquire the asset.|
|No upfront cost to the buyer, other than commissions.||Buyers pay a premium for the options contract.|
|Price can fall below $0.||Price can never fall below $0.|
Options are contracts that establish an agreement for the trade of a certain underlying asset, such as a stock or currency. An options contract typically reflects 100 shares of the asset.
Buyers of options have the right to buy or sell the asset, but they are not required to. These contracts are known as derivatives because they are tied to the underlying assets they represent but are not the assets themselves.
To enter into an options contract, the buyer pays what is known as a premium in options terminology. The premium is non-refundable, so that is what the buyer risks when they enter the contract.
Types of Options
The two types of options are call options and put options.
• Call options, or calls, allow the option holder to buy an underlying asset at the strike price any time until the expiration date.
• Put options, or puts, allow the option holder to sell an asset at a certain price for the duration of the contract.
Example of a Call Option
An investor buys a call option for XYZ stock with a strike price of $40 per share, paying a $3 premium to enter into the contract. The contract expires in six months, and the stock is currently trading at $39 per share.
Within the next six months, if the stock price goes up to $50, the buyer can choose to exercise their call option and purchase the stock at the $40 strike price. They could then sell that stock on the market for $50 per share and make a $10 per share profit, minus the cost of the premium.
Or, the buyer could choose to sell the option itself rather than exercising it and buying the shares. The contract will have gone up in value as the price of the stock went up, so the buyer would likewise see a profit.
If the price of the stock is below the $40 strike price at the time of expiration, the contract would expire worthless, and the buyer’s loss would be limited to the $3 premium they paid upfront.
Example of a Put Option
Meanwhile, if an investor owns a put option to sell XYZ stock at $80, and XYZ’s price falls to $60 before the option expires, the investor will gain $20 per share, minus the cost of the premium.
If the price of XYZ is above $80 at expiration, the option is worthless, and the investor loses the premium paid upfront.
Who Trades Options
Experienced investors who are able to buy and sell on margin are typically those who trade options contracts.
Because options investing entails a certain amount of risk, as well as access to a margin account, retail investors may need approval from their brokerage in order to trade options.
Futures contracts are similar to options in that they set a specific price and date for the trade of an underlying asset. One of the most common forms are futures on commodities, which speculators can use to make a profit on changes in the market without actually buying or selling the physical commodities themselves. Futures are also available for individual stock market indices and other assets. Rather than paying a premium to enter the contract, the buyer pays a percentage of the notional value called an initial margin.
Example of a Futures Contract
Let’s look at an example of a futures contract. A buyer and seller enter a contract that sets a price of $40 per bushel of wheat. During the life of the contract, the market price may move above $40, putting the contract in favor of the buyer, or below $40, putting it in favor of the seller. If, for example, the price of wheat goes to $45 at expiration, the buyer would make $5 per bushel, multiplied by the number of bushels the contract controls.
Who Trades Futures?
Some of the most commonly traded futures contracts are related commodities, including agricultural products (e.g. wheat, soybeans), energy (e.g. oil), and metals (e.g. gold. silver). There are also futures on major stock indices, such as the S&P 500, government bonds, and currencies.
Traders of futures are generally divided into two camps: hedgers and speculators. Hedgers typically have a position in the underlying commodity and use a futures contract to mitigate the risk of future price movements. An example of this is a farmer, who might sell a futures contract against a crop they produce, to hedge against a fall in prices and lock in the price at which they can sell their crop.
Speculators, on the other hand, take some risk in order to profit from favorable price movements in the underlying asset. These include institutional investors, such as banks and hedge funds, as well individual investors. Futures enable speculators to take a position on the price movement of an asset without trading the actual physical product. In fact, much of trading volume in many futures contracts comes from speculators rather than hedgers, and so they provide the bulk of market liquidity.
Futures vs Options: Main Differences
So far, we’ve described some of the differences in how options and futures are structured and used. Here are some additional factors to consider when comparing the two instruments.
Trading options comes with certain risks. The buyer of an option risks losing the premium they paid to enter the contract. The seller of an option is at risk of being required to purchase or sell an asset if the buyer on the other side of their contract exercises the option.
Futures can be riskier than options because of the high degree of leverage they offer. A trader might be able to buy or sell a futures contract putting up only 10% of the actual value. This leverage magnifies price changes, meaning even small movements can result in substantial profit or loss.
With futures, the value of the contract is marked-to-market daily, meaning each trading day money may be transferred between the buyer and seller’s accounts depending on how the market moved. An option buyer, on the other hand, is not required to post any margin, since they paid the premium upfront.
Futures pricing is relatively intuitive to understand. The price of a futures contract should approximately track with the current market price of the underlying asset, plus the cost of carrying or storing the physical asset until maturity.
Option pricing, on the other hand, is generally based on the Black-Scholes model. This is a complicated formula that requires a number of inputs. Changes in several factors other than the price of the underlying asset, including the level of volatility, time to expiration, and the prevailing market interest rate can impact the value of the option.
Holding constant the price of the underlying asset, futures maintain their value over time, whereas options lose value over time, also known as time decay. The closer the expiration date gets, the lower the value of the option gets. Some traders use this as an options trading strategy. They sell options contracts, knowing that time decay will eat away at their value over time, betting that they will expire worthless and pocketing the premium they collected upfront.
Futures and options are popular types of investments for those interested in speculation and hedging. But these two types of derivatives contracts operate quite differently, and present different opportunities and risks for investors.
There are several differences between futures and options, most notably that futures contracts specify an obligation — for the long side to buy, and for short side to sell — the underlying asset at a specific price on a certain date in the future On the other hand, options contracts give the contract holder the right to buy or sell the underlying asset at a specific price, but not the obligation to do so (which removes some of the risk).
Another distinction, though, is that a futures contract is a simpler transaction in a way, as it only involves a buyer who wants to buy the contract/asset, and the seller who wants to sell it. Options, however, come in two flavors, puts and calls, which involve different rules and potential outcomes. Puts give investors the option to buy a certain asset, while calls give investors the right to sell a certain asset.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.