What Is The Difference Between Options And Futures?

An investor who purchases an options contract has the opportunity, but not the duty, to purchase (or sell) shares at a predetermined price at any time before the contract expires. In contrast, a futures contract, unless the holder's position is closed earlier, mandates a buyer to buy the underlying security or commodity—and a seller to sell it—on a certain future date.

 

Investors might speculate on changes in market price or utilize financial derivatives like options and futures to manage risk. An investor can purchase a security at a set price by a specific date using both options and futures. The laws governing options and futures contracts, as well as the risks they present to investors, differ significantly.

 

•    The value of two different derivatives contracts, options and futures, depends on market movements for the underlying index, securities, or commodity.

 

•    An option allows the buyer the freedom to purchase (or sell) an asset at a predetermined price at any point during the term of the contract, but it does not obligate them to do so.

 

•    A futures contract binds the buyer to buy and the seller to sell and deliver a certain asset at a predetermined future date.

 

•    However, the parties to commodity futures contracts are normally required to make and accept deliveries on the settlement date. Futures and options positions may be traded and terminated prior to expiration.

 

•    The value of an underlying stock, index future, or commodity serves as the foundation for options. An investor who purchases an options contract has the right to buy or sell the underlying asset at a predetermined price for the duration of the contract. Options may not be exercised by investors.

 

•    Financial derivatives include options. Until they exercise an option to buy stock, option holders do not possess the underlying shares or have access to shareholder rights.

 

•    Stock options normally grant the option holder the right to purchase or sell 100 shares of the underlying stock prior to the expiration date of the option contract at the strike price chosen. The option premium is the cost of the option.

 

•    NOTE-The U.S. equity options market is open during regular stock trading hours, from 9:30 am to 4:00 pm EST. On holidays when stock exchanges are closed, options exchanges are also closed.

 

•    Call options and put options are the only two types of options. The right to purchase a stock at the strike price before the contract expires is granted by a call option. The right to sell a stock at a certain price is granted to the holder of a put option.

 

•    Let's examine an illustration of each, starting with a call option. An investor purchases a call option to purchase the stock XYZ for $50 at some point in the following three months. The stock is trading at $49 right now. The call buyer can exercise their option to purchase the stock at $50 if the stock rises to $60. Following that, the buyer can sell the shares for $60, making $10 per share in profit.

 

•    Alternatively, since the call option is worth $10 per share, the option buyer can just sell the call and keep the profit. At the time the contract expires, if the option's price is below $50, it has no value. The premium, which serves as the option's up-front payment, is forfeited by the call buyer.

 

•    When XYZ's price drops to $80 prior to the option expiring, an investor who has a put option to sell the stock at $100 will profit by $20 per share, less the cost of the premium. If the price of XYZ is higher than $100 when the option expires, it is worthless, and the investor forfeits the upfront premium.

 

•    Before the option expires, either the put buyer or the writer can close down their position to lock in a profit or loss. The writer accomplishes this by purchasing the option, whereas the buyer accomplishes this by selling the option. The option to sell at the strike price is also available to the put buyer.

 

•    A futures contract is a commitment to purchase or sell a commodity at a specified price in the future. The best way to comprehend futures contracts is to think about them in terms of commodities like maize or oil. They are a true hedge investment. In the event that market prices decline before the crop can be delivered, for instance, a farmer might want to lock in a reasonable crop price. In order to guard against future price increases, the buyer also wishes to lock in a price.

 

•    Let's use an example to illustrate. Let's say two traders agree on a price on a corn futures contract of $7 per bushel. The contract buyer earns $2 per bushel if the price of maize increases to $9. On the other side, the seller misses out on a better offer.

 

•    Beyond corn and oil, the futures market has substantially grown. In some jurisdictions, futures can be bought on both individual equities and indices like the S&P 500. Since 2020, single-stock futures have not been offered in the United States. A futures contract's full value does not have to be paid up front by the buyer. Instead, they provide an initial margin equal to a portion of the price.

 

•    For instance, a contract for oil futures covers 1,000 barrels of oil. A $100 oil futures contract requires the buyer to take a $100,000 risk. The buyer might have to put down several thousand dollars, and if oil prices fall later, they might have to raise their investment.

 

•    NOTE-Institutional investors are the primary customers of futures markets. These can include refineries looking to lock in the price of feed or livestock farmers want to hedge the cost of crude.

 

•    Speculators, consumers, and producers of commodities are all served by futures markets. Futures contracts can shield both buyers and sellers from significant changes in the underlying commodity's price.

 

•    Along with serving regular traders, they also cater to institutional investors looking to profit on anticipated changes in market prices for the underlying securities or commodity. Financial speculators often plan to exit their position before the contract is finalized instead of buying the underlying commodity.

 

•    NOTE-Trading times for futures may be different from those for stocks and options. 

 

There are more distinctions between options and futures in addition to those mentioned above. These other key distinctions between these two financial products are listed below.

 

Options transactions typically include risk due to their complexity. Options on calls and puts both carry some risk. A stock option's risk is established by its price, or premium, when an investor purchases it. In the worst event, if the options expire worthless, the option premium paid will be a total loss.

 

Selling a put option, however, exposes the seller to potential losses that might be much more than the premium earned from a potential drop in the value of the shares that the stock option is based on. The seller is still obligated to acquire the stock at $50 per share if a put option grants the buyer the right to sell the shares at $50 per share but it drops to $10.

 

The price paid up front is the only risk assumed by the option buyer. The price of an option changes depending on a number of variables, such as the strike price's distance from the current value of the underlying security and the amount of time left until expiration. This premium is given to the put option seller, also known as the option writer.

 

On the opposite side of the trade is the option writer. Compared to option purchasers, option sellers assume a greater level of risk. The seller of a call option can lose an unlimited amount on an increase in share price because there is no upper constraint on share price. To reduce their risk, option sellers may be owners of the underlying stock.

 

Both the option seller and the buyer have the opportunity to exit their positions in the options market.

 

Options may be dangerous, but futures for the individual investor may be more risky. Both the buyer and the seller are obligated under futures contracts. Futures positions are marked to market each day, and the buyer or seller may need to put up more money if the price of the underlying instrument changes.

 

NOTE-Futures contracts necessitate a substantial capital outlay. Futures are inherently riskier due to the requirement to sell or acquire at a specific price.

 

Options are bought and traded on futures, which adds to the confusion. However, it enables for a comparison of the similarities and differences between options and futures

 

For a premium of $2.60 per contract, an options buyer could have acquired a call option with a strike price of $1,600 and a February 2019 expiration date. This call's owner would have had a bullish outlook on gold and would have been entitled to take the underlying gold futures position up until the option's expiration following the end of the market on February 22, 2019.

 

The investor would have used their option to purchase the futures contract if gold prices increased above the $1,600 strike price. Should this not have been the case, the investor would have let the options contract expire. The $2.60 premium they paid for the contract represented their maximum loss.

 

Instead, the investor may have bought a gold futures contract. 100 troy ounces of gold are the underlying asset of one futures contract. This implies that on the delivery date indicated in the futures contract, the buyer must accept 100 troy ounces of gold from the seller. The contract will either be sold before the delivery date or rolled over to a new futures contract, assuming the trader has no interest in actually possessing the gold.

 

At the conclusion of each trading day, the investor's account is credited or debited in accordance with the incremental gain or loss as the price of gold changes. The buyer of a futures contract is still liable to pay the seller the higher contract price on the delivery date even if the market price of gold declines below the contract price the buyer committed to.