Options vs. Futures: An Overview
Options and futures are both financial products that investors use to make money or to hedge current investments. Both are agreements to buy an investment at a specific price by a specific date.
- An option gives an investor the right, but not the obligation, to buy (or sell) shares at a specific price at any time, as long as the contract is in effect.
- A futures contract requires a buyer to purchase shares, and a seller to sell them, on a specific future date unless the holder's position is closed before the expiration date.
The options and futures markets are very different, however, in how they work and how risky they are to the investor.
- Options and futures are similar trading products that provide investors with the chance to make money and hedge current investments.
- An option gives the buyer the right, but not the obligation, to buy (or sell) an asset at a specific price at any time during the life of the contract.
- A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date unless the holder's position is closed prior to expiration.
Call Options and Put Options
There are only two kinds of options: call options and put options. A call option is an offer to buy a stock at a specific price, called a strike price, before the agreement expires. A put option is an offer to sell a stock at a specific price.
In either case, options are a derivative form of investment. They are offers to buy or offers to sell shares, but don't represent actual ownership of the underlying investments until the agreement is finalized.
As an example, say an investor opens a call option to buy stock XYZ at a $50 strike price sometime within the next three months. The stock is currently trading at $49. If the stock jumps to $60, the call buyer can exercise the right to buy the stock at $50. That buyer can then immediately sell the stock for $60 for a $10 profit per share. Alternatively, the option buyer can simply sell the call and pocket the profit, since the call option is worth $10 per share.
If the option is trading below $50 at the time the contract expires, the option is worthless. The call buyer loses the upfront payment for the option, called the premium.
The Risks of Options
The risk to the buyer of a call option is limited to the premium paid up front. This premium rises and falls throughout the life of the contract. It is based on a number of factors, including how far the strike price is from the current underlying security's price as well as how much time remains on the contract. This premium is paid to the investor who opened the put option, also called the option writer.
The option writer is on the other side of the trade. This investor has unlimited risk. Assume in this example that the stock goes up to $100. The option writer would be forced to buy the shares at $100 per share in order to sell them to the call buyer for $50 a share. In return for a small premium, the option writer is losing $50 per share.
Either the option buyer or the option writer can close their positions at any time by buying a call option, which brings them back to flat. The profit or loss is the difference between the premium received and the cost to buy back the option or get out of the trade.
A put option is the right to sell shares at the strike price at or before expiry. A trader buying this option hopes the price of the underlying stock will fall.
For example, if an investor owns a put option to sell XYZ at $100, and XYZ’s price falls to $80 before the option expires, the investor will gain $20 per share, minus the cost of the premium. If the price of XYZ is above $100 at expiration, the option is worthless and the investor loses the premium paid up front.
Either the put buyer or the writer can close out their option position to lock in a profit or loss at any time before its expiration. This is done by buying the option, in the case of the writer, or selling the option, in the case of the buyer. The put buyer may also choose to exercise the right to sell at the strike price.
A futures contract is the obligation to sell or buy an asset at a later date at an agreed price.
Futures are most understandable when considered in terms of commodities such as corn or oil. Futures contracts are a true hedge investment. A farmer might want to lock in an acceptable price up front in case market prices fall before the crop can be delivered. The buyer wants to lock in a price up front, too, in case prices soar by the time the crop is delivered.
Assume two traders agree to a $50 per barrel price on an oil futures contract. If the price of oil moves up to $55, the buyer of the contract is making $5 per barrel. The seller, on the other hand, is losing out on a better deal.
Who Trades Futures?
There's a big difference between institutional and retail traders in the futures market.
Futures were invented for institutional buyers. These dealers intend to actually take possession of barrels of crude oil to sell to refiners, or tons of corn to sell to supermarket distributors. Establishing a price in advance makes the businesses on both sides of the contract less vulnerable to big price swings.
Retail buyers, however, buy and sell futures contracts as a bet on the price direction of the underlying security. They want to profit from changes in the price of futures, up or down. They do not intend to actually take possession of any products.
The market for futures has expanded greatly beyond oil and corn. Stock futures can be purchased on individual stocks or on an index like the S&P 500.
In any case, the buyer of a futures contract is not required to pay the full amount of the contract up front. A percentage of the price called an initial margin is paid.
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. The buyer may be required to pay several thousand dollars for the contract and may owe more if that bet on the direction of the market proves to be wrong.
Futures Are Bigger Bets
Options are risky, but futures are riskier for the individual investor.
A standard option contract is for 100 shares of stock. If the underlying stock is trading at $30, then the total stake is $3,000. A standard gold contract is 100 ounces of gold. If gold is trading at $1,300 per ounce, the contract represents $130,000. Option contracts are smaller by default, although an investor can buy multiple contracts.
Futures Are Riskier
When an investor buys a stock option, the only financial liability is the cost of the premium at the time the contract is purchased. However, when a seller opens a put option, that seller is exposed to the maximum liability of the stock’s underlying price. If a put option gives the buyer the right to sell the stock at $50 per share but the stock falls to $10, the person who initiated the contract must agree to purchase the stock for the value of the contract, or $50 per share.
Futures contracts tend to be for large amounts of money. The obligation to sell or buy at a given price makes futures riskier by their nature.
Futures contracts, however, involve maximum liability to both the buyer and the seller. As the underlying stock price moves, either party to the agreement may have to deposit more money into their trading accounts to fulfill a daily obligation.
This is because gains on futures positions are automatically marked to market daily, meaning the change in the value of the positions, up or down, is transferred to the futures accounts of the parties at the end of every trading day.
Options Are Optional
Investors who purchase call or put options have the right to buy or sell a stock at a specific strike price. However, they are not obligated to exercise the option at the time the contract expires. Options investors only exercise contracts when they are in the money, meaning that the option has some intrinsic value.
Purchasers of futures contracts are obligated to buy the underlying stock from the seller of the contract upon expiration no matter what the price of the underlying asset is.
Example of an Options Contract
To complicate matters, options are bought and sold on futures. But that allows for an illustration of the differences between options and futures.
In this example, one options contract for gold on the Chicago Mercantile Exchange has as its underlying asset one COMEX gold futures contract.
An options investor might purchase a call option for a premium of $2.60 per contract with a strike price of $1,600 expiring in February 2019.
The holder of this call has a bullish view on gold and has the right to assume the underlying gold futures position until the option expires after market close on February 22, 2019. If the price of gold rises above the strike price of $1,600, the investor will exercise the right to buy the futures contract. Otherwise, the investor will allow the options contract to expire. The maximum loss is the $2.60 premium paid for the contract.
Example of a Futures Contract
The investor may instead decide to buy a futures contract on gold. One futures contract has as its underlying asset 100 troy ounces of gold.
That means the buyer is obligated to accept 100 troy ounces of gold from the seller on the delivery date specified in the futures contract. Assuming the trader has no interest in actually owning the gold, the contract will be sold before the delivery date or rolled over to a new futures contract.
As the price of gold rises or falls, the amount of gain or loss is credited or debited to the investor's account at the end of each trading day.
If the price of gold in the market falls below the contract price the buyer agreed to, the futures buyer is still obligated to pay the seller the higher contract price on the delivery date.
What's The Difference Between Options And Futures?
Options and futures may sound similar, but they are very different. Futures markets are easier to understand but carry considerable risk due to the size of many of the contracts.
Buying options can be quite complex, but the risk is capped to the premium paid. Options writers assume more risk. In fact, option writing is best left to experienced options traders.