- Futures and options are derivative securities, meaning their value is derived from an underlying asset, such as a stock or commodity.
- Futures contracts require the contract holder to buy or sell an asset on a specific date, while options give the choice, not the obligation, to do so.
- Futures and options can be risky, but the risk to the individual investor may be higher for futures because of the requirement to sell.
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Futures and options are two types of derivative securities. This means that neither options nor futures have intrinsic value. Instead, they derive their value from an underlying asset, such as a commodity, currency, or stock index. Both are financial contracts that fix the terms of a transaction to take place at a future date.
Options, as their name suggests, give the buyer the opportunity, but not the obligation, to complete the transaction. Futures contracts, on the other hand, require that the agreed transaction takes place when the contract expires.
What are futures?
Futures contracts are agreements in which a buyer agrees to buy an underlying asset, most often a commodity, at a fixed price on a specified future date. For example, a futures buyer may agree to buy 100 barrels of oil in the future for a specified price, and the futures seller must meet those terms.
Futures contracts began as a way for farmers to lock in the prices of their crops to protect themselves against bad weather, insects, and anything else that could threaten their crops. From those early days, futures contracts have evolved, and now their underlying assets can be other types, such as US Treasuries. There are also futures contracts linked to stock indices like the S&P 500.
Futures contracts can be bought on margin, which means traders only have to keep a fraction of what they trade in their account. Typically, the requirement is 3% to 12%, so a futures trader could invest $100,000 with as little as $3,000 of their own cash. This greatly increases the wins – as well as the losses.
Investing in futures contracts is considered very risky due to their low margin requirements and closing collateral. Therefore, this type of trading is usually left to professional investors.
What are the options?
In the United States, options contracts give buyers the right to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a fixed price, called strike price, at the latest on a specific date in the future. The main difference here is that options do not bind the buyer of the contract to complete the transaction. If they don’t exercise the option, they lose the premium or the amount they paid to buy the contract.
Like futures, options are most often bought and sold by institutional investors, who tend to use them as part of complex trading strategies to hedge their portfolios. However, they are also gaining popularity with individual investors. Unlike futures contracts, the underlying assets from which options derive their value are generally stocks and not commodities.
In the options market, you have the choice of buying or selling contracts to buy or sell. Options can be less risky when you’re a long because they don’t require a purchase, and the most you can lose is the premium you paid for the contract. As a seller, the risk is greater because you would be bound by the terms of the contract regardless of what happens to the value of the underlying asset.
Key Differences Between Futures and Options
Here is a summary of the most notable differences between futures and options:
An example of futures vs options
Futures and options can be used as a hedge against risk in a given portfolio. Thus, a futures contract or an options contract can be opened with a
like the S&P 500 as the underlying asset. Here’s how someone who wanted to bet on the future direction of the S&P 500 could do so using futures or options:
Use Index Futures
S&P 500 futures contracts are valued at the value of the index multiplied by $250. This means that if the S&P 500 were at 5,000 points, the cost of the futures contract would be 5,000 times $250, or $1.25 million. Keep in mind that the investor does not have to pay this full amount. They only have to maintain the required margin to negotiate the contract.
If the futures trader buys a contract at 5,000 points and it rises to 5,100 points on the expiration date, the contract is now worth $1.75 million and the trader has made a profit of $50,000.
Using index options
Again, suppose the trader is speculating that the S&P 500 will rise and it currently has a value of 5,000. Imagine the trader buys a call option with a strike price of 5,050 and an ask price of $11.50. Investors pay a premium for options, and $11.50 is the premium in this case.
Index options are multiplied by $100 to determine the premium. So the price premium for this call option is $1,150, or $11.50 times $100.
Now, suppose all goes as planned and the S&P 500 rises to 5,050. This allows the investor to exercise the call option for a profit. To determine net profit, we take 5050 and subtract 5000 with both numbers multiplied by $100. That gives us $5,000. Then subtract the $1,150 premium for a net profit of $3,850.
Risks associated with futures and options
Futures and options can be quite risky, but each type of contract comes with its own set of risks.
“In futures and options, the big risk is that the price moves against you before the contract expires,” says Anthony Denier, CEO of trading platform Webull.
With options contracts, this can be less risky for the buyer, who has the choice not to exercise the option if the conditions are not met.
“Since the buyer will only exercise the option if it is in their favor, the seller will likely lose money,” Denier said. “If the market moves against the buyer, he would lose his entire investment.”
On the other hand, futures contracts are different because the position will always close, even if it is unfavorable to the buyer. In addition, futures investors must maintain their accounts daily.
“Futures contracts are marked to market every day, which means the investor may have to put in more money to hold their positions,” says Denier. “Also, if the buyer of the contract does not close it before the expiration date, they will take delivery of the assets, which can be a problem if it is hundreds of barrels of oil.”
Nevertheless, futures and options can be both quite complex and very risky. They are therefore not a good choice for beginners. If you decide to get involved, be sure to do careful and thorough research and consider seeking advice from an investment professional before putting your money at risk.