Futures and options are both derivative instruments, which means they derive their value from an underlying asset or instrument. Both futures and options have their own advantages and disadvantages. One of the advantages of options is obvious. An option contract provides the contract buyer the right, but not the obligation, to buy or sell an asset or financial instrument at a fixed price on or before a predetermined future month. That means the maximum risk to the buyer of an option is limited to the premium paid.
But futures have some significant advantages over options. A futures contract is a binding agreement between a buyer and seller to buy or sell an asset or financial instrument at a fixed price at a predetermined future month. Though not for everyone, they are well suited to certain investments and certain types of investors. (For related reading, see: Futures Fundamentals)
Below, we present five advantages of futures over options:
- Futures are great for trading certain investments: Futures may not be the best way to trade stocks, for instance, but they are a great way to trade specific investments such as commodities, currencies and indexes. Their standardized features and very high levels of leverage make them particularly useful for the risk-tolerant retail investor. The high leverage allows those investors to participate in markets to which they might not have had access otherwise.
- Fixed upfront trading costs: The margin requirements for major commodity and currency futures are well-known because they have been relatively unchanged for years. Margin requirements may be temporarily raised when an asset is particularly volatile, but in most cases, they are unchanged from one year to the next. This means a trader knows in advance how much has to be put up as initial margin. On the other hand, the option premium paid by an option buyer can vary significantly, depending on the volatility of the underlying asset and broad market. The more volatile the underlying or the broad market, the higher the premium paid by the option buyer. (For more, see: What does a futures contract cost?)
- No time decay: This is a substantial advantage of futures over options. Options are wasting assets, which means their value declines over time—a phenomenon known as time decay. A number of factors influence the time decay of an option, one of the most important being time to expiration. An options trader has to pay attention to time decay, because it can severely erode the profitability of an option position or turn a winning position into a losing one. Futures, on the other hand, do not have to contend with time decay.
- Liquidity: This is another major advantage of futures over options. Most futures markets are very deep and liquid, especially in the most commonly traded commodities, currencies and indexes. This gives rise to narrow bid-ask spreads and reassures traders they can enter and exit positions when required. Options, on the other hand, may not always have sufficient liquidity, especially for options that are well away from the strike price or expire well into the future.
- Pricing is easier to understand: Futures pricing is intuitively easy to understand. Under the cost-of-carry pricing model, the futures price should be the same as the current spot price plus the cost of carrying (or storing) the underlying asset until the maturity of the futures contract. If the spot and futures prices are out of alignment, arbitrage activity would occur and rectify the imbalance. Option pricing, on the other hand, is generally based on the Black-Scholes Model, which uses a number of inputs and is notoriously difficult for the average investor to understand.
The Bottom Line
While the advantages of options over futures are well documented, futures also have a number of advantages over options such as their suitability for trading certain investments, fixed upfront trading costs, lack of time decay, liquidity and easier pricing model. (For further reading, see: Futures Fundamentals.)