In the enormous world of financial markets, any risk-averse investor is looking to gain more profit while also lowering the potential risk in their work. This means that they are seeking an instrument to not only offer a strategic tool to manage risk but also amplify the potential return. The suggested tools for this situation are futures and options. These two robust financial instruments have emerged as the perfect solution in the financial arena. We will analyze the complexity and functionality of these tools in this futures vs options article.
We aim to unravel the differences between futures vs options. We will explore their fundamental differences, applications, and the strategic considerations that investors must weigh in order to make informed decisions. As we explore the world of financial derivatives, it’s essential to see how futures and options work together and differ. They give investors various ways to handle the unknowns of the future.
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What Are Futures?
Futures are a type of contract that obligates the buyers and sellers to buy and sell a specific quantity of an asset. The strike price is predetermined, as is the date of exercise. The underlying asset could be of various types, such as a commodity, currency, cryptocurrency, or stock. Note that the expiry date shall be set for a time in the future.
Future contracts usually serve different purposes, such as:
- Hedging against price fluctuations
- Speculating on future movements of price
- Providing liquidity in the market
And the list goes on and on.
Investors can either execute buy or sell (long or short) positions in futures trading depending on their forecast of future price movement. Its nature is different than other financial tools because of the investors’ ability to choose an expiration date and determine the size of the contract. They also contribute to liquidity and efficiency in the market.
Futures Trade Example
Imagine John, who is a corn farmer. Every year, he plants 500 acres of corn. After the corn is planted, John is exposed to the risk that corn prices could fall before he harvests. So he could sell his crop in the fall and lose profits. To protect against falling prices, John decides to hedge his risk by selling five corn futures contracts. Each contract represents 5,000 bushels of corn. Since John expects to harvest about 150,000 bushels of corn (300 bushels per acre), selling five futures contracts allows him to lock in a price for his entire crop.
If corn is trading at $4 per bushel when John sells the futures contracts, he locks in a price of $4 per bushel for his crop. When it comes time to sell his actual corn in the fall, if prices have fallen to $3.50, John can still sell his corn for $4 per bushel by offsetting his futures position at a profit. The futures contracts allow John to hedge against downside price risk and lock in an acceptable selling price for his corn crop.
What Are Options?
In the financial world, options are mainly referred to as a type of contract that grants the investors the right to buy or sell. The period of the contract and the strike price shall be predetermined as well. However, the holder of the option is not obligated to exercise the contract (execute the trade). The mentioned asset could also be a stock, commodity, currency, or cryptocurrency. The options contracts are traded on various financial exchanges around the world.
We have two primary types of options in contracts:
- Call options
- Put Options
We will proceed to explain the difference between these two.
Call Options
A call option gives the holder of the contract the right to buy an asset at a predetermined price before or at the time of expiry. Investors often buy call options when they anticipate that the price of an asset is going to be higher than a specified amount. That is because they can exercise the option and buy the asset at a lower price than the market and then sell it on the market for a profit.
Put Options
A put option gives the holder the right to sell an asset at a predetermined price before or at the expiration date. Investors usually buy put options when they expect the price of the underlying asset to drop lower than a specific amount. In this case, they can buy the asset at a lower price from the market and sell it at a higher rate (by exercising the option).
Why Trade Options?
The nature of options provides flexibility and various strategies for investors. The two primary use cases of options include:
- Hedging: Options can be used to protect portfolios from volatility and adverse price movements. For instance, you can prevent drawdown by simultaneously buying an asset and a put option at the same price.
- Speculation: You can also trade options to speculate on the direction of price movements without owning the asset itself. This is due to its nature as a derivative. They also offer the chance to use leverage, something most speculators seek.
Options Trade Example
Maria, a stock trader, believes ABC Company’s stock price will increase over the next few months. She wants to profit from this increase while limiting her downside risk if she is wrong, so she decides to buy call options on ABC stock.
She purchases ten call option contracts with a strike price of $50 that expire in six months. Since each options contract covers 100 shares of stock, Maria has the right to buy 1,000 shares of ABC at $50 per share before the options expire. Maria pays a premium of $2 per share for the options, for a total upfront cost of $2,000.
Over the next few months, ABC stock rises to $60 per share. Maria decides to exercise her call options, buying 1,000 shares at the strike price of $50. She then immediately sells the shares at the market price of $60. After accounting for the $2,000 paid in premiums, Maria makes a profit of $8,000 on the options trade.
Futures vs Options: Which One Should You Trade?
In this futures vs options article, we learned that futures are types of contracts that obligate the investor to either buy or sell an asset at a predetermined date and price. Meanwhile, in an options contract, the investor has the right (but not any obligations) to buy or sell an asset within a specified period at a predetermined price.
On paper, there might not be much of a difference futures vs options. There are some small differences that will diversify the interest in each one. We’re going to go over the main features in the case of futures vs options.
Futures:
- Contract obligation: Futures contracts possess a legal agreement to either buy or sell the asset at a predetermined date and price.
- Leverage: Traders can control a large position with a relatively small amount of capital. In fact, they only need to deposit a fraction of the contract’s value.
- Market liquidity: Futures contracts are often traded on organized exchanges. They provide liquidity as they can be easily bought or sold.
- Settlement: Settlement can occur through physical delivery of the asset or cash settlement, depending on the contract specifications.
- Clearinghouse role: A clearinghouse acts as an intermediary. It ensures the fulfillment of contracts and manages the risk associated with default.
Options:
- No obligation: Options provide the holder of the contract with the right to buy or sell the asset at a predetermined price, but there are no obligations.
- Expiration date: Options have a limited lifespan and expire on a specific date. The holder can exercise the option before or at the expiration date.
- Strike price: The pre-agreed price of trading the asset, which is known in advance.
- Premium: The buyer pays a premium for the option, which is the cost of acquiring the right. Sellers receive the premium as a return for taking on the obligation.
- Flexibility: Options offer a variety of strategies for investors, including hedging and speculation.
- Liquidity: Options can be traded on exchanges, providing liquidity. Specific options may have lower liquidity compared to heavily traded stocks.
To recap futures vs options: in a futures contract, the date and price of trading the asset are predetermined. Moreover, investors are obligated to buy or sell the asset. Whether they buy or sell, they tolerate an unlimited amount of risk for a potential reward. The profits and losses of the trade are realized at the expiration of the contract.
For options, there are no obligations and even more flexibility for the investor regarding what to do with the asset and when to do it. Similar to futures, the contract itself can be traded. When trading options, you bear a limited risk for an unlimited profit potential.
You can visit both futures and options charts on TradingView.
Risks and Limitations of Futures vs Options
Like any other phenomenon in the world of finance and trading, there are risks associated with futures and options. Some of the significant risks of futures trading are:
- Leverage risk: Futures contracts usually have a significant amount of leverage. While leverage can boost gains, it also magnifies losses. Traders may be required to deposit additional funds to keep the position open if the market moves against them.
- Market risk: Futures prices are subject to market fluctuations. They can be influenced by various factors such as economic indicators, geopolitical events, and market sentiment.
Options trading also involves various risk factors. Here is a list of primary risks of options trading:
- Premium cost: Options buyers pay a premium for the right, and options sellers receive a premium for taking on the obligation. While being limited, the premium itself is the monetary risk the investor tolerates.
- Complexity: Options trading strategies can be complex, especially for those new to derivatives. Understanding various strategies, including spreads and combinations, requires a good grasp of the market and options pricing.
- Market Risk: Like futures, options are subject to market risks. If the price of the asset doesn’t move as anticipated, the potential profit of the option decreases.
- Risk of assignment: Option sellers may be assigned to fulfill their obligations at any time before expiration. This can result in unexpected transactions and risks for the option publisher.
What are Binary options?
Until now, we have focused on comparing futures vs options, and we have a grasp on the nature of both. Yet, there is another financial derivative called the binary option. It’s an option that has only two outcoming results, hence the name, binary option.
In case the trader is right, they receive a fixed, predetermined amount as profit. On the contrary, if the option’s condition is not met, the entire investment is lost. So, a binary option is a kind of money deal where you get one of two results.
For a more comprehensive guide on binary options trading, click here.
Advantages of Binary Options vs Futures and Traditional Options
The whole concept of binary options is easy to understand. This reason alone makes it a favorable trading instrument for low-skilled and beginner traders.
The main advantages of trading binary options are as follows:
- Simplicity: In binary options, the outcome is either yes or no. Either you win a fixed amount, or you lose the entire investment. Meanwhile, in traditional futures or options, a large number of complex strategies are involved. Therefore, the trader should possess a strong understanding of markets.
- Limited Risk: When trading binary options, the amount invested and the potential loss are known upfront by the trader. As a result, risk management is easier and more straightforward. On the other hand, in futures trading, the potential risk of loss is basically unlimited, hence making it harder for the risk to be controlled.
- Cost-effectiveness: The initial investment is fixed and is usually lower in binary options compared to futures and traditional options.
- Flexibility: Binary options are much more flexible with their expiration time and strike price. While traditional options have more flexibility for creating complex strategies, the same complexity can be seen as a disadvantage to some traders.
- Margin requirements for buyers: Unlike futures and traditional options, buyers are free of the need to deal with margin complexities for binary options.
- Predictable Payouts: In binary options, payouts are fixed and known from the beginning. Yet, in futures and traditional options contracts, the returns could vary because they depend on the magnitude of market movements.
Conclusion
Whether an investor or a trader is low-skilled or not, some instruments could help him maximize his potential return on the financial market. The better you understand the market’s complexity, the higher your chance of gaining considerable profits. In this futures vs options article, we tried to provide sufficient insight so you can choose wisely.
Depending on your strategy, the first choice you must make in derivatives trading is solving the dilemma of futures vs options. If you are trying to minimize the risk and prefer a more flexible contract, a traditional option contract is most certainly the best bet. However, if you want to be able to amplify your return and have leverage on in the contract, futures are the answer. Finally, in case you are looking for a straightforward trading instrument with a well-defined risk profile, binary options are for you.
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