Many people buy and sell stocks or ETFs before getting into futures and options. These derivatives are more complex instruments that allow investors to incur greater risks in exchange for higher potential rewards. These contracts give investors exposure to the price movement of more assets than people who prioritize owning the underlying asset. This guide will explore how futures and options work so you can decide if either of them is right for you.
What are Futures?
A purchase or sale of stock happens in real-time. Futures trading is a contract to make a sale or purchase in the future.
A futures contract has a buyer and a seller, both of whom agree that an asset will be bought or sold for a specific price on a specific day. The asset can be a commodity, a currency, or even an index, like the Dow Jones Industrial Index. A common use for futures contracts is to remove pricing volatility within commodity markets.
The volume of futures contracts can be an indication of where the price or index will move in the short term, but there are some subtleties to understanding futures volume. Another element must be considered, called "open interest," which is a measurement of how many orders haven't been executed because the price hasn't reached the price for those orders.
Trading Futures
Traders look for changes in volume, technical indicators, and other factors when trading futures. Rising volume combined with rising open interest can confirm a trend while rising volume and a falling open interest instead suggests a liquidation. Futures contracts are traded on futures exchanges, such as the Chicago Mercantile Exchange (CME); S&P 500 futures have the highest volume of futures contracts at the time of this writing, followed by the 10-year T-note, the 5-year T-note, crude oil, and then corn.
Futures contracts can represent nearly any index or commodity, but some indexes and commodities generate more interest and trading opportunities.
What are Options?
A stock option is a derivative because it's not the stock itself but rather an option to buy or sell the stock. Options give you the choice but not the obligation to buy or sell the underlying security. Investors who sell options are obligated to fulfill their end of the bargain if the contract holder wants to exercise the option.
Call Options
A call option is an option to buy at a future date. It's a bit like browsing at your favorite store and choosing an item for layaway — but there is a charge for putting the item on layaway. This charge, called the premium, is the cost of the options contract. It makes sense that there would be a charge because by buying the option you haven't actually purchased the item.
However, you can control that item, in this case, a stock, for a small fraction of the cost of purchasing the stock.
Put Options
A put option is an option to sell at a future date. Put options can be used in various investment strategies, including a bet on a market downturn, but one of the most common strategies is using put options as a simple insurance policy. Put options can protect your downside if the market makes a big downward swing. Let's say you bought shares in an S&P 500 index ETF (SPY) at $400.
Buying put options against those shares for 10% less than your purchase price of $400 allows you to limit your loss to $40 per share if the share price dips more than 10%. Of course, you'll have to pay a premium for this option and the option is only effective for a limited amount of time.
In that regard, it's a lot like insurance: you pay for it just in case you need it — but you may not ever need it. Like insurance, if you want continued protection, you'll have to renew your policy — or buy more puts in this case.
Trading Options
Options traders can exchange calls and puts. Calls gain value when the underlying asset's price increases, while puts gain value when an asset loses value. Options traders can either go long or short on an option. Long options traders pay a premium and then realize gains if the investment moves in the right direction. Short options traders sell these derivatives and realize a premium right away. These traders can lose money if the investment moves in an unfavorable direction.
Futures vs. Options: Similarities
Futures and options are important derivatives in the financial markets. They offer investors opportunities for speculation, hedging, and portfolio diversification. Both instruments help manage risk and take advantage of price changes in underlying assets. However, they are structured differently. Despite this, futures and options have similar features that attract traders and investors. Understanding these similarities can help anyone interested in derivative trading. We will discuss the key similarities between futures and options, focusing on their roles in risk management and market strategies.
No Margin, No Service
Futures trading and options trading require margin accounts. This doesn't exclude IRAs entirely, but a third-party custodian for the account must be established as an extra hurdle. For retail traders, an individual brokerage account (with margin) is most frequently used, which also helps keep retirement investments separate from more exotic trades like futures or options trading.
Insurance Uses
Both futures and options can be a simple sort of insurance to either keep pricing within an understood range or to protect the downside for investment positions.
Leverage
Futures and options give traders the ability to use leverage, which lets them manage a bigger position with a smaller initial investment. This can increase both possible profits and losses, making these tools attractive for traders looking for higher returns, but they can also be riskier for those who are not experienced in the market.
Futures vs. Options: Differences
Futures and options are important financial tools. Investors use them for hedging, speculation, and improving portfolio performance. Both help manage risks from price changes in underlying assets like commodities, stocks, and currencies. However, they are different in structure and obligations. Futures contracts require buyers and sellers to make a transaction at a set price on a future date. In contrast, options give the buyer the right, but not the obligation, to make a transaction. This overview highlights the main differences between futures and options for better understanding in financial markets.
Contract Dates Affect Trading
Futures contracts only allow the underlying asset to be traded on the date specified in the contract. Options can be exercised at any time prior to the option expiration date.
Options Are Optional
Futures and options also differ in the requirement to make a trade. Futures are a trade — if held. In most cases, the futures contract is sold before the expiration date, preventing the trader from having to take delivery of 1,000 barrels of oil, live cattle, pallets filled with pork bellies — or whatever else is traded. Options, on the other hand, don't need to be exercised at all. If there's no business or investment reason to exercise the option, it can expire with the only cost being the premium for the contract.
Risk of Loss
In futures, both parties must adhere to the terms of the agreement, which can lead to unlimited losses if the market shifts unfavorably. On the other hand, with options, the buyer's risk is confined to the premium paid, while the seller may still encounter unlimited losses based on market fluctuations.
Futures vs. Options: Which is Better?
Futures and options are both types of derivatives that serve different purposes for investors. Futures contracts require the buyer to purchase, or the seller to sell, an asset at a set price by a certain date, which means investors face unlimited risk if the market moves against them. On the other hand, options provide investors with the right, but not the obligation, to make a trade, offering greater strategic flexibility and reduced risk, as they have the option to let the contract expire.
Investors looking for leverage and bigger profits often choose futures because they can manage a larger position with less capital. However, this increases risk, making futures more appropriate for those who can handle higher risk. Conversely, options attract those who focus on managing risk and customizing their approach, enabling them to use different trading strategies while still having some protection against losses.
In short, futures can provide significant returns due to leverage, while options offer a flexible way to manage risk and opportunities based on one's investment objectives. Recognizing these important distinctions is essential for tailoring investment strategies to fit personal situations.
Frequently Asked Questions
What is the difference between options and futures?
A futures contract involves an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. An options contract gives the buyer the right to buy the asset at a fixed price.
Can you make more money in futures versus options?
Futures move up faster and have more leverage than options to increase your total returns.
Are options and futures risky?
Options and futures are riskier than holding onto the underlying asset. However, these derivatives have much greater potential. Investors should assess their portfolio diversification, financial goals, and risk tolerance before trading futures and options.