Options and futures are both derivatives, but the intricacies of trading either investment strategy mean there are fundamental differences investors need to know to make informed trading choices.
Futures mean entering a contract to buy or sell an asset, commodity or other security at a fixed price, date, and amount. Traders can close or exit positions before expiry, particularly if they do not wish to receive physical delivery of an asset, but the principle remains the same.
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Trading options are different because although the underlying asset might be identical, you are paying for the right to execute a transaction but have zero obligation. For example, you might pay for the option to purchase shares at a set value, or use options to hedge risk, always with the choice not to execute depending on market movements.
Both financial derivatives and trading strategies have pros and cons. Still, understanding how they work, the costs, payoffs and implications are essential because futures and options contracts may appear similar on the surface but have substantial variances at the contract level.
Key Differences Between Options And Futures
The primary difference between options and futures lies in the obligation. With futures, you buy a derivative contract with a finite action required – you must purchase or sell the underlying asset or exit the trade.
Options carry no such obligation but can equally be closed or traded before the expiry date.
However, options can carry less value if they are not executed; if markets move in a different direction and the option isn’t needed, you still need to cover the transactional and contractual cost, even if you never exercise the option given.
Options are traded contracts that give the holder the right to exercise an option and are valued based on the underlying asset, such as a commodity, index futures or stock.
Depending on the contract terms, the investor can usually sell or buy options at any stage before expiry – although the rules vary slightly in the EU, where holders can only exercise options on the actual expiry date.
The investor can decide not to exercise the option, in which case they lose nothing besides the price of the contract, but can use options to safeguard against losses or to speculate on the possibility that share prices will fall.
Options are neither an asset, nor offer ownership of the underlying asset. The price specified in the option is called the strike price, and the cost paid for the contract is the premium.
Stock options usually mean the investor can buy or sell stocks at the specified price, including the expiry date. So, for example, if a trader suspects the share price will drop beneath their original purchase value, they might buy an option to sell at that rate, offsetting the potential capital loss.
Call and put options trading
Options can be either call or put:
- Call options mean the trader has the right to purchase an asset at the specified strike price.
- Put options allow them the right to sell the asset at a predetermined rate.
Call options are useful if an investor is interested in purchasing a stock but is uncertain about how prices will move. They might buy an option rather than invest in the stock outright and see how the stocks perform, with less capital invested in the trade to mitigate the loss if prices do not move in their favour.
For example, a trader evaluating a share investment worth £50 a stock might buy a call option based on a £60 strike price. They can buy at this rate even if the stocks hit a £70 market valuation and sell immediately for a £10 profit per share.
The same trader will not make any gain if the stocks remain at £50, and the option will not carry any value. However, if the stock value is uncertain or volatile, they have not taken the bigger risk of investing in shares that could fall.
Put options work the other way around. For example, an investor with an existing shareholding might anticipate a drop in market values and take a put option to sell their current stocks at a fixed rate, often similar to or slightly higher than the original cost.
If stock values rise, they will profit; if they fall, the trader can exercise their option to ensure they do not make a loss. Either way, they will pay the put option premium but hedge their risk exposure.
Futures are another derivative but work differently from options because both parties to the agreement are obligated to complete the transaction on the expiry date unless they exit the contract or roll it over.
An everyday use of futures is a hedge where investors or corporations need to guarantee the prices they will pay for commodities for future supply periods. For example, businesses buy futures in forex to ensure a pre-agreed exchange rate for larger global transactions or use futures to lock in pricing for raw materials.
There is a risk vs reward, as with options. If, for example, a trader has purchased a futures contract to buy a commodity at a fixed rate, and the prices rise, they will profit – they will still be able to buy the asset at the strike price, regardless of current market values.
The downside is that if prices do not rise or even fall, they are still obligated to complete the transaction and pay the higher rate included in the futures contract.
This risk is worth taking in many trading sectors because projects and tenders are priced without exposure to loss-making price rises.
Investors can also use futures to speculate or hedge against risks that other portfolio assets will fluctuate adversely, although institutional traders primarily use them.
Trading Options Vs Futures: Pros And Cons
While the underlying valuation basis and future timescales associated with both futures and options differ, one is an obligation and the other a choice. There are other variations that traders consider when deciding which derivative to use.
Risk differs because options can be complex. In addition, the premium paid for an option is a sunk cost because if the option is not exercised or becomes worthless, there is no way to recoup the expense.
Put options can also make exaggerated losses because the premium the trader will benefit if stock values decline lower than the loss they will make if the opposite happens.
However, futures can be higher risk because the price risk linked to an option is limited to the premium paid. Futures are contractual obligations, so if the futures contract is not wound down or sold, the holder must uphold their side of the agreement, whether favourable or not.
Futures positions change daily and are marked according to real-time market conditions so margin requirements can alter at short notice.
The margin capital required to purchase futures is also higher. In contrast, an option might be a relatively small expense to pay for assurances that an investor can exercise their option if they need to correct losses or benefit from increased profitability generated by value changes in the underlying asset.
Trading Options Vs Futures FAQ
Both options and futures are contracts based on future transactions, where the trader either purchases the contract to buy or sell an underlying asset at the strike price or pays a premium to have the option to do so.
These derivatives can be beneficial but are as volatile as the market price linked to the asset or stock in question. However, options can be safer because investors may have more time to make trading decisions since they react differently to asset price movements than futures.
The margin paid for options is normally lower, but futures can be advantageous because they allow for greater leverage, usually have higher liquidity and are generally less complex financial instruments.
Although futures carry a higher risk factor, they can also provide greater returns. Futures contracts have a higher notional value and are often heavily leveraged, allowing access to larger profits and potentially larger losses.
Any investment product carries risk, but options are sometimes lower risk than equities since the trader requires a lower capital margin to take a position on the future value of the stocks.
Investors should understand the risks associated with any position they enter and be prepared to use stop-loss orders where necessary to mitigate heavy losses.
Traders can roll over contracts to extend the expiry date, sell futures or options contracts, or take a stop-loss measure if they need to close their position. Their trading strategy, risk appetite, and exposure to negative price movements will determine the right time to exit.
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