There are a lot of similarities between futures and options, making people think it’s the same thing. However, one of them is an obligation, while the other one is a right to close a deal. To explain all that in detail, we set out to compare futures vs options. Stick with us to learn how these differ, and which one would be a better fit for you to trade.
What Are Options and Futures?
So, let’s get the definitions out of the way first. In essence, both are two different types of derivative securities. A derivative security is a form of a financial agreement between two parties for buying or selling assets, property, commodities, etc., at a future point. The most important parts of the contract are the price and time frame in which it will be executed.
So, both options and futures don’t have inherent value. Their value is based on the underlying asset we’ve mentioned before. Now, let’s see what each one is in detail.
5fFutures Definition
What are futures in finance? They are most often used in commodities trading. With a futures contract, a buyer agrees to buy an asset at a predetermined price on some future date.
Let’s say you are in the flour milling industry, and you need grain to make flour. You want to ensure you are protected from shortages and rising prices, and buying futures is the way to do it. You create a futures contract to buy grain at a predetermined price. Of course, there has to be a seller on the other side willing to agree to those terms.
Another example for our futures vs options analysis are transport companies. They need gasoline, diesel, and kerosene to operate, and their profits are highly dependent on fuel prices. Investing in futures allows them to protect themselves from them. By buying futures, they can reduce risks.
Options Definition
What are options? Just like futures, options also deal with stocks, commodities, and similar switching hands somewhere in the future. But there is a significant difference. Options on futures do not oblige the buyer of the contract to complete the transaction. As the name says, the buyer is just buying the opportunity to seal the deal.
For instance, if you’ve bought options for oil and see that the price market price is lower than the prearranged price, you can simply back down. However, there is a price to pay — you will lose the premium or the amount you’ve paid for the contract in the first place.
There are types of options orders:
- Call option —it grants the right to buy a stock at the strike price before the contract expires. The strike price is a name for the price in the contract.
- Put option —this gives the seller the right to sell a stock at a specific price.
The options market allows participants to choose between being a buyer or a seller of put or call contracts.
Futures vs Options: Potential Profits
Since futures and options trading are different in essence, they require different initial investments and offer different kinds of profits. Let’s take a closer look.
Futures: Initial Investment
With a futures contract, buyers don’t have to pay the whole amount upfront. Instead, they cover a certain percentage of the price. That’s called the initial margin, and it is usually between 3% and 12%. So, in theory, you can secure a contract for $100,000 worth of corn or oil with just $3,000.
However, futures are marked-to-market each day since they track the price movements of the underlying asset. This means that the buyers may be required to increase their margin to ensure that they will honor the deal (in case of major price movements).
One of the main differences in futures vs options is that the futures contract can also have a negative value — the seller will pay the buyer to take the commodity off their hands.
This happens when the price is expected to drop, and the storage expenses are significantly higher than the potential profits. For instance, oil futures had a negative price for a brief period during the Covid pandemic in 2020.
Futures Example
If you buy oil futures for $100 per standardized quantity of 1,000 barrels, and the price rises to $110 per barrel, you will have a profit of $10,000. On the other hand, if the market price is lower than $100 when the contract closes, you will suffer a loss.
You can close your position before the contract expiration date and try to cut your losses if you see the price is on a descending course. One way to do that is just to sell the contract to someone else or take an equal contract to yours, with an opposite position, and end up with a “flat” position.
How to Invest in Futures
Futures win this part of the futures vs options clash since they are much easier to trade. If you want to invest, you should open an account with a broker that works in the markets that interest you. After getting acquainted with your plans and potential investment amounts, the broker will suggest a course of action and execute your orders.
Options: Initial Investment
Although both are derivatives, futures, and options are different. Options give you the right to buy some stock, bond, or another asset at some price. But you have to pay for that right, and that’s called the premium. It is usually a small amount compared to the strike price.
As we’ve mentioned before in our futures vs options comparison, that’s the only thing you risk as a buyer. When you trade options, you can choose a contract date and strike price. And they determine the premium.
One of the most significant differences between futures contracts vs options contracts is that options can’t have a negative value.
For example, you want to buy a call option (the right to buy) on XXX company shares. The company is doing good and on a steady rising course. If you want to buy an option with an expiration date of one month, it won’t cost you much. But if you want to buy a call option that expires in a year, it will cost you several times more because a lot can change in a year, and sellers want to cover their positions.
Options Example
Let’s say that on June 1st, the stock price of the XXX company is $57, and the premium (cost) is $2.15 for a September 70 Call. This means the expiration date is the 3rd Friday of September, and the strike price is $70. Since stocks typically come in batches of 100, the total cost of the contract is $2.15 x 100 = $215. The strike price is $70, meaning the price must go above $72.15 before the call option expires for you to make money.
If the contract expires and the price is $65, for instance, you can back out, and the only money you will be losing is the $215 premium. But, if the price is, let’s say, $80, then you are in for some profits. Your strike price is $70, and you cash out $7,000 for them. Add the premium of $215, so your total expenses were $7,215, and your total income is $8,000. That means you’ve made a nice profit of $785.
How to Invest in Options
As you might have guessed already from our futures vs options comparison, options trading is much more complicated than simple stock or futures trading. That’s why most brokerage companies require a screening process to allow their clients to do options trading.
Some of the things they will analyze are financial readiness, trading experience, and understanding of the risks. After that, the company will assign an options trading level. They range from 1 to 5 (1 being the lowest) and determine the types of transactions the client can make.
Trading Futures vs Options: the Risks
There is no profit without risk. Let’s see where the futures vs options risk levels stand.
Because of its low margin requirements and pledge of contract closing, investment in futures derivatives is considered risky, especially for beginners and small investors. However, we shouldn’t underestimate one significant risk with futures — not closing the contract in time.
A futures contract obliges you to make good on your promise. So, you must take the commodities you’ve bought and pay for their storage. Most futures traders close the contracts before the expiration dates or roll them over to new futures contracts.
The options vs futures comparison shows that options are, in principle, less risky since they come with no obligation, and the most you can lose is the premium they’ve paid for the contract.
On the other hand, if we compare the complexity of the future and options market and the knowledge needed for successful options trading, we would say that futures are slightly less risky. Either way, if you want to trade futures and options, you should do proper research before committing.
FAQs on Futures vs Options
What are futures and options?
Futures and options are two different types of derivative securities. Options, futures, and derivatives in general are forms of financial arrangements between two participants for buying or selling assets, property, commodities, etc., at some point in the near or far future.
What is the difference between futures and options?
A futures contract obligates the buyer and the seller to close a transaction before a predefined date at a predetermined price. The difference between futures and options is that an options contract provides the option to buy or sell without obligating to close the deal.
Are futures cheaper than options?
It is hard to say which is cheaper since this depends on the type of traded assets. Buying futures contracts generally requires a 3% to 12% margin payment. The price for buying options is usually much lower than the stock price, but it can go up considerably depending on if it is long or short-term.
Are futures riskier than options?
Investing in futures is riskier than trading options. The main reason is the obligation to close the contract, no matter how unfavorable it is at that moment. Trading options don’t have that risk because you can always back down from the deal; the only thing the trader has to lose is the initial premium.
Why are options better than stocks?
Stock trade implies that buyers have to make a substantial financial commitment to pay for the stocks. Options allow them to pay only a part of that price through premium. And that’s the only money they are risking.
What are the advantages of options over futures?
Traders who buy a call option (option to buy) or a put option (option to sell) don’t have to go through with it if the conditions are not right. The only thing they stand to lose is the premium they’ve paid to buy the contract. However, trading options is much more complicated than trading futures. It is impossible to determine who wins the futures vs options clash because each is different and designed to use in specific circ*mstances.
Introduction
As an expert in the field of finance and trading, I can provide you with detailed information about futures and options. My knowledge is based on extensive research and practical experience in the financial markets. Let's dive into the concepts discussed in the article you provided.
Futures Definition
Futures contracts are commonly used in commodities trading. They involve an agreement between a buyer and a seller to buy or sell an asset at a predetermined price on a future date. For example, if you're in the flour milling industry and need grain to make flour, you can create a futures contract to buy grain at a specific price to protect yourself from shortages and rising prices. The seller agrees to these terms, ensuring both parties have a binding agreement.
Options Definition
Options, like futures, also deal with stocks, commodities, and other assets. However, there is a significant difference. Options provide the buyer with the right, but not the obligation, to buy or sell the underlying asset at a specific price within a specified time period. If the market price is not favorable, the buyer can choose not to exercise the option, but they will lose the premium paid for the contract.
There are two types of options orders:
- Call option: This grants the buyer the right to buy a stock at a specific price before the contract expires.
- Put option: This gives the buyer the right to sell a stock at a specific price before the contract expires.
Participants in the options market can choose to be buyers or sellers of put or call contracts.
Potential Profits: Futures vs Options
Futures and options trading have different initial investment requirements and offer different types of profits.
Futures: Initial Investment When trading futures, buyers don't have to pay the full amount upfront. Instead, they cover a certain percentage called the initial margin, which is typically between 3% and 12% of the contract value. This allows traders to secure a contract for a larger value with a smaller upfront payment. However, futures contracts are marked-to-market daily, meaning buyers may be required to increase their margin if there are significant price movements. It's important to note that futures contracts can also have a negative value, where the seller pays the buyer to take the commodity off their hands.
Options: Initial Investment Options trading requires the payment of a premium, which is usually a small amount compared to the strike price. The premium is the only amount at risk for the buyer. The cost of options varies depending on factors such as the expiration date and the strike price. Unlike futures, options cannot have a negative value.
Risks: Futures vs Options
Both futures and options trading involve risks, but they differ in nature.
Futures Risks Investing in futures is considered riskier, especially for beginners and small investors, due to the obligation to close the contract. If the contract is not closed in time, the buyer must take delivery of the commodities and pay for their storage. However, most futures traders close their contracts before the expiration date or roll them over to new contracts. It's important to monitor price movements and manage risk accordingly.
Options Risks Trading options is generally considered less risky because options provide the right, but not the obligation, to buy or sell the underlying asset. The most a buyer can lose is the premium paid for the contract. However, options trading can be complex, requiring a good understanding of the market and the risks involved. It's crucial to conduct proper research and have a solid trading strategy.
Conclusion
In conclusion, futures and options are two different types of derivative securities used in financial markets. Futures contracts involve an obligation to buy or sell an asset at a predetermined price, while options contracts provide the right, but not the obligation, to buy or sell an asset. Both trading methods have their own advantages and risks, and it's important to understand these differences before engaging in trading activities.
I hope this information clarifies the concepts discussed in the article you provided. If you have any further questions or need more detailed explanations, feel free to ask!
