Futures and options can both be used to speculate on the price movements or hedge existing investments.
Both futures and options are derivative securities, meaning their value is derived from an underlying asset, such as a stock or commodity.
Futures require the contract holder to buy or sell an asset on a specific date, while options give the choice, not the obligation, to do so.
Both futures and options can be risky, but the risk to the individual investor can be greater for futures because of the obligation to sell.
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Futures and options are two types of derivative securities. This means that neither options nor futures have inherent value. Instead, they derive their value from an underlying asset, such as a commodity, currency, or stock market index. Both are financial contracts that set the terms of a transaction to take place at a future date.
Options, as the name implies, give a buyer the option, but not the obligation, to go through with the transaction. Futures, on the other hand, require that the agreed-upon transaction takes place when the contract expires.
What are futures?
Futures contracts are arrangements in which a buyer agrees to purchase an underlying asset, most often a commodity, for a set price on a specified future date. For instance, a futures contract buyer may agree to buy 100 barrels of oil in the future for a specified price, and the contract seller must make good on those terms.
Futures contracts began as a way for farmers to lock in prices for their harvests to protect themselves against bad weather, insects, and anything that may threaten their crops. Since those early days, futures have evolved, and now their underlying assets may be other types, such as US Treasuries. There are also futures contracts tied to equity indexes like the S&P 500.
Futures contracts can be purchased on margin, which means traders only have to maintain a fraction of what they are trading in their account. Typically, the requirement is 3%-12%, so a futures trader could invest $100,000 with as little as $3,000 of their own cash. This stands to greatly magnify gains — as well as losses.
Investing in futures is considered highly risky due to their low margin requirements and guarantee of closing. Hence, this type of trading is usually left to professional investors.
What are options?
In the US, options contracts give buyers the right to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset for a set price, known as the strike price, on or before a specific date in the future. The key difference here is that options don’t obligate the buyer of the contract to go through with the transaction. If they don’t exercise the option, they lose the premium, or the amount they paid to purchase the contract.
Like futures, options are most often bought and sold among institutional investors, who tend to use them as part of complex trading strategies to hedge their portfolios. However, they have been gaining popularity among individual investors as well. Unlike futures, the underlying assets from which options derive their value are typically stocks, not commodities.
In the options market, you have the choice of either being a buyer or a seller of put or call contracts. Options can be less risky when you’re a buyer because they don’t require a purchase, and the most you might lose is the premium you paid for the contract. As a seller, the risk is greater because you would be bound by the terms of the contract regardless of what happens to the value of the underlying asset.
Key differences between futures and options
Here’s a summary of the most notable differences between futures and options:
Require the holder to buy or a sell an asset for a set price on a specific date
Give the holder the option to buy or sell the underlying asset on or before a specific date, without the obligation to do so
Traded from Sunday at 6 p.m. ET to Friday at 4:30 or 5:00 p.m. ET, depending on the commodity
Traded from 9:30 a.m. ET to 4:30 p.m. ET Monday through Friday (the same as stocks)
Most often use commodities as their underlying asset
Most often use stocks as their underlying asset
Carry high levels of risk for both the buyer and seller because the position will always close on the specified date
Risk can be lower for a buyer because a buyer isn’t required to exercise the option
An example of futures vs. options
Both futures and options can be used as a hedge against risks in a given portfolio. Thus, either a futures contract or an options contract can be opened with an index fund such as the S&P 500 as its underlying asset. Here’s how someone who wanted to bet on the future direction of the S&P 500 could do so using either futures or options:
Using index futures
S&P 500 futures are priced at the value of the index times $250. That means if the S&P 500 was at 5,000 points, the cost of the futures contract would be 5,000 times $250, or $1.25 million. Keep in mind the investor doesn’t have to put up this full amount. They only have to maintain the margin required to trade the contract.
If the futures trader buys a contract at 5,000 points and it rises to 5,100 points by the expiration date, the contract is now worth $1.75 million, and the trader has earned a $50,000 profit.
Using index options
Again, assume the trader speculates that the S&P 500 will rise and that it currently has a value of 5,000. Imagine the trader buys a call option with a strike price of 5,050 and an ask price of $11.50. Investors pay a premium for options, and $11.50 is the premium in this case.
Index options are multiplied by $100 to determine the premium. Thus, the price premium for this call option is $1,150, or $11.50 times $100.
Now, suppose that all goes according to plan, and the S&P 500 rises to 5,050. This allows the investor to exercise the call option for a profit. To determine the net profit, we take 5,050 and subtract 5,000 with both numbers multiplied by $100. That gives us $5,000. Then, subtract the $1,150 premium for a net profit of $3,850.
Quick tip: Futures contracts can be purchased on margin, but options contracts can only be sold on margin. The latter is seen as highly risky because it can lead to losses greater than your initial investment.
The risks involved in futures and options
Both futures and options can be quite risky, but each type of contract comes with its own set of risks.
“In both futures and options, the big risk is that the price moves against you before the contract expires,” says Anthony Denier, CEO of trading platform Webull.
With options contracts, it can be less risky for the buyer, who has the choice not to exercise the option if the conditions aren’t right.
“Since the buyer will only exercise the option if it’s in their favor, the seller will probably lose money,” Denier says. “If the market moves against the buyer, then they would lose their entire investment.”
On the other hand, futures are different because the position will always close, even if it’s unfavorable for the buyer. In addition, futures investors must maintain their accounts daily.
“Futures are marked to market each day, which means the investor may have to put up more money to hold their positions,” says Denier. “Also, if the buyer of the contract doesn’t close it before the expiration date, they will take delivery of the assets, which can be a problem if it’s hundreds of barrels of oil.”
Nevertheless, futures and options can both be quite complex and very risky. Thus they are not a good choice for beginners. If you do decide to get involved, be sure to do careful and thorough research and consider getting advice from an investment professional before putting your money at risk.
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