Options vs. Futures: An Overview
Options and futures are two similar sounding trading products but are very different in practice. 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.
The fundamental difference between options and futures lies in the obligations they put on their buyers and sellers. An option gives the buyer the right, but not the obligation, to buy (or sell) a certain 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.
Stock futures and stock options are deadline-based agreements between buying and selling parties for a share of equities. Both contracts provide investors with strategic opportunities to make money and hedge current investments. Before an investor can decide to trade either futures or options, they must understand the four primary differences between the two.
A call option is the right to buy a stock at the strike price before or at expiry (for American options). For instance, assume there is a call option to buy stock XYZ at a $50 strike price, 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 of factors, including how far the strike price is from the current underlying security'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 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 a 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 of 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.
A futures contract is the obligation to sell or buy a commodity (or another 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 seller 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 where a big difference between institutional and retail traders comes in. Retail traders buy and sell futures contracts betting on the price direction of the underlying security. They want to profit off the change in the 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 any other underlying product of a futures contract). Yet institutions will use futures contracts for this purpose; that is why futures were 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 thousand dollars but then may have to put up more money/margin if the contract is going against them.
Aside from commissions, an investor can enter into a futures contract with no upfront cost, whereas buying an options position does require the payment of a premium. When buyers of call and put options purchase a derivative, they pay a one-time fee called a premium, and sellers of call and put options collect the premium. The value of the contracts decays as the settlement date approaches. However, the premium price rises and falls, allowing users to sell their calls and puts for a profit ahead of the expiration date. Those who sell options can purchase call options to cover the size of their position as well.
Stock futures can either be purchased on single stocks (SSFs) or focus on the broader performance of an index like the S&P 500. However, with stock futures, the buying party pays something other than a contract premium at the point of purchase. Buying parties pay something known as initial margin, which is a percentage of the price to be paid for the stocks.
Compared to the absence of upfront costs of futures, the option premium can be seen as the fee paid for the privilege of not being obligated to buy the underlying security in the event of an adverse shift in prices. The premium is the maximum a purchaser of an option can lose.
Another key difference between options and futures is the size of the underlying position. Generally, the underlying position is much larger for futures contracts, and the obligation to buy or sell this certain amount at a given price makes futures riskier for the inexperienced investor.
When someone 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 put options for purchase, they are exposed to maximum liability on 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, however, offer maximum liability to both the buyer and seller of the agreement. As the underlying stock price shifts in the favor against either the buyer or seller, parties may be obligated to inject additional capital into their trading accounts to fulfill daily obligations.
Those who purchase call or put options receive 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. Investors only exercise contracts when they are in the money, meaning that the option has intrinsic value because the price makes sense. If the option is out of the money, and the option lacks intrinsic value, the contract buyer is under no obligation to purchase the stock.
Purchasers of futures contracts are obligated to buy the underlying stock from the seller of that contract upon expiration no matter what the price is of the underlying asset. If the futures contract calls for the purchase of the stock at $100, but the underlying stock is valued at $80 at contract expiration, the buyer must buy at the agreed upon price. Still, it is very rare for stock futures to be held to their expiration date.
How Gains Are Received
The final major difference between these two financial instruments is the way the gains are received by the parties. The gain on an option can be realized in the following three ways: exercising the option when it is deep in the money, going to the market and taking the opposite position, or waiting until expiry and collecting the difference between the asset price and the strike price. In contrast, gains on futures positions are automatically marked to market daily, meaning the change in the value of the positions is attributed to the futures accounts of the parties at the end of every trading day, but a futures contract holder can realize gains also by going to the market and taking the opposite position.
Options and Futures Example
Let's look at an options and futures contract for gold. One options contract for gold on the Chicago Mercantile Exchange (CME) has the underlying asset as one COMEX gold futures contract, not gold itself. An investor looking to buy an option may purchase a call option for $2.60 per contract with a strike price of $1600 expiring in Feb 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 Feb 22, 2019. If the price of gold rises above the strike price of $1,600, the investor would exercise his right to obtain the futures contract, otherwise, he may let the options contract expire. The maximum loss of the call options holder is the $2.60 premium he paid for the contract.
The investor may instead decide to obtain a futures contract on gold. One futures contract has its underlying asset as 100 troy ounces of gold. The buyer is obligated to accept 100 troy ounces of gold from the seller on the delivery date specified in the futures contract. If the trader has no interest in the physical commodity, he can sell the contract before delivery date or roll over to a new futures contract. If the price of gold goes up (or down), the amount of gain (or loss) is marked to market (i.e. credited or debited) in 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, he is still obligated to pay the seller the higher contract price on the delivery date.
Stock options provide investors with both the right to buy a stock (but not the obligation) and the right to sell the same stock (but not the obligation) through calls and puts, respectively. But stock options also provide investors with a breadth of flexible strategies unavailable through futures trading. Each strategy offers different profit potentials for investors and speculators.
Stock futures, on the other hand, offer very little flexibility once a contract is opened. As noted, investors purchase the right and obligation for fulfillment once a position is opened.
Risk: Futures vs. Options
One difference between a futures contract and options is that a future is an obligation, whereas an option is a right (not necessarily an obligation). With futures, both parties face a lot of risks as prices could move against them. Companies enter these agreements 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 the seller has a 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, then 100 shares of stock are $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 a 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.
What's The Difference Between Options And Futures?
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, the risk is capped to the premium paid. Options writer assume more risk, and therefore option writing should be left to experienced options traders.
Deciding to use stand-alone options, stock futures or a combination of the two requires an assessment of individual expectations and investment goals. One of the first questions an investor must ask is how much risk they are willing to take on in their investment strategies. Options trading provides less upfront risk for buyers given the lack of obligation to exercise the contract. This provides a more conservative approach, particularly if traders use a number of additional strategies like bull call and put spreads to improve the odds of trading success over the long term. After you understand the risks, we recommend taking a look at the list of best options brokers.
- Both 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.