Option and futures are two similar sounding trading products, but are very different in practice. Buying an option gives a person the right, but not the obligation, to buy or sell something at a certain price in the future. A futures contract is an agreement by a buyer and seller that obliges them to buy or sell the underlying, at the price they agreed on, at a future date. Both products are used by retail traders and institutional investors, but often in different ways. Let's take a deeper look at options and futures and their differences.

Option Contracts

There are call options and put options. A trader can buy a put or a call, or a trader can write a put or a call. 

A call option is the right to buy a stock at the strike price before or at expiry (American option). For instance, assume there is a call option to buy stock XYZ at $50 (strike), and the option expires in three months. The stock is currently trading at $49. If before, or at, expiry the stock is trading above $50, say at $60, the call buyer can exercise their right to buy the stock at $50. They buy the stock at $50 from the call writer and are able to sell the stock at $60 for a $10 profit per share. Alternatively, the option buyer can simply sell the call to reap the profit, since the call option is worth $10 per share, plus any time value that remains. If the option is trading below $50 (strike) at expiry, the option is worthless and the call buyer loses what they paid for the option, called the premium.

The risk to the call option buyer is limited to the premium paid. This premium is based on a number factors, including how far the strike price is from the current underlying's price, as well as how long there is till expiry. This premium is received by the option writer.

The option writer is on the other side of the trade. They have unlimited risk (unless they are covered) because a stock price could go up indefinitely. Assume in the scenario that the stock goes up to $100. The option writer would need to buy stock at $100 because they are obligated to sell shares to the call buyer at $50. For the small premium received this option writer is losing $50 per share. Like the option buyer, the option writer can close their position at any time by buying a call option which brings them back to flat. Their profit or loss is the difference between the premium received and the cost of the premium to buy back the option or to get out of the trade.

A put option is the right to sell XYZ at the strike price at or before expiry. A trader buying this option wants the price of the underlying stock to fall. If you own a put that allows you to sell XYZ at $100, and XYZ’s price falls to $80 before the option expires, you’ll gain $20 per share, less the cost of the premium paid. If the price of XYZ is above $100 at expiry, then the option is worthless and you lose the premium you paid for the option. The put buyer can continue to profit all the way to the stock falling to $0.

The maximum gain for the writer of the put option is the premium received, yet the risk is that the price falls below the strike price and losses could mount.

Assuming they are American options, the put buyer and writer can close out their option position to lock in a profit loss at any time before expiry by buying the option in the case the writer or selling the option in the case of the buyer. The put buyer may also choose to exercise, which means they utilize their right to sell at the strike price.

Futures Contracts

A futures contract is the obligation to sell/buy a commodity (or other asset) at a later date, at an agreed price. 

Assume two traders agree to $100 on an oil futures contract. The buyer agrees to buy oil at $100 at expiry, and the sellers agrees to sell oil at $100. If the price of oil moves up to $105, the buyer of the contract at $100 is making money because they have an agreement to buy at $100 even though oil is currently trading at $105. The seller on the other hand is losing, because they could be selling at $105, but instead they agreed to sell at $100.

Here is a where a big difference between institutional and retail traders comes in. Retails traders buy and sell futures contracts betting on the price direction of the underlying. They want to profit off the change in price of the futures contract. They do not intend to actually take possession of physical barrels of oil, or to have to deliver barrels of oil (or other underlying product of a futures contract). Yet institutions will use futures contracts for this purpose; that is why futures where invented. Futures contracts allow companies to buy products they need or sell products they produce at agreed prices on future dates. This allows them to make plans for their business and guarantee product inflows/outflows down the road.

Someone who buys or sells a futures contract is not required to put up the full amount of what the contract represents. For example, an oil futures contract is for 1,000 barrels of oil. An agreement to buy an oil futures contract at $100 represents the equivalent of a $100,000 agreement. But the buyer and seller are not required to put up all this capital up front. Rather, they are only required to put up several thousands dollars, but then may have to put up more money/margin if the contract is going against them.

Main Differences Between Futures and Options                    

One difference between futures and options is that a future is an obligation, where as an is right (not necessarily an obligation). With futures, both parties face a lot of risk as prices could move against them. Companies are okay with this, because they need to buy or sell the underlying product anyway, and are just looking to lock in a price. This differs from an option contract where the buyer has limited risk and seller has large risk.

Another difference is that the cost of an option is the premium, while futures traders put up margin and then may have to put up more capital if the price goes against them. The potential to have to put up more capital does not apply to option buyers, but does apply to option writers. 

Futures contracts are generally larger than default option contracts. For example, most option contracts are for 100 shares of stock. If the underlying stock is trading at $30,100 shares of stocks is $3,000 ($30 x 100). Compare that to a standard gold contract which is 100 ounces of gold. If gold is trading at $1,300 per ounce, the contract represents $130,000. Therefore, the size of futures contracts can pose greater risk, since even small moves in the underlying price of the asset can mean big dollar amounts gained or lost on the futures contract. Option contracts are smaller by default, although it is possible to buy multiple contracts (same with futures) in order to increase the size of the bet.

The Bottom Line

Options and futures may sound similar, but they are very different. Futures markets are a bit simpler to understand, but carry considerable risk for an uninformed investor due to the size of many of the contracts. Options trading can be quite complex. Although, if buying options risk is capped to the premium paid. Options writer assume more risk, and therefore option writing should be left to experienced options traders.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.