An options contract gives an investor the proper, but not the duty, to purchase (or sell) shares at a specified price at any time before the contract’s expiration. Against this, a futures contract requires a buyer to buy the underlying security or commodity—and a seller to sell it—on a selected future date, unless the holder’s position is closed earlier.
Options and futures are two varieties of economic derivatives investors can use to take a position on market price changes or to hedge risk. Each options and futures allow an investor to purchase an investment at a selected price by a selected date. But there are essential differences in the foundations for options and futures contracts, and within the risks they pose to investors.
Key Takeaways
- Options and futures are two kinds of derivatives contracts that derive their value from market movements for the underlying index, security or commodity.
- An option gives the client the proper, but not the duty, to purchase (or sell) an asset at a selected price at any time throughout the lifetime of the contract.
- A futures contract obligates the client to buy a selected asset, and the vendor to sell and deliver that asset, at a selected future date.
- Futures and options positions could also be traded and closed ahead of expiration, however the parties to the futures contracts for commodities are typically obligated to make and accept deliveries on the settlement date.
What’s The Difference Between Options And Futures?
Options
Options are based on the worth of an underlying stock, index future, or commodity. An options contract gives an investor the proper to purchase or sell the underlying instrument at a selected price while the contract is in effect. Investors may select to not exercise their options.
Options are financial derivatives. Option holders don’t own the underlying shares or enjoy shareholder rights unless they exercise an choice to buy stock.
Options contracts for stocks typically provide the proper to purchase or sell 100 shares of the stock at the required strike price before the contract expiration date, and the value of the choice is referred to as its premium.
Within the U.S., the equity options market is open from 9:30am – 4:00pm EST; the identical as normal stock trading hours. Options exchanges are also closed on holidays when stock exchanges are closed.
Sorts of Options: Call and Put Options
There are only two sorts of options: Call options and put options. A call option confers the proper to purchase a stock on the strike price before the agreement expires. A put option gives the holder the proper to sell a stock at a selected price.
Let’s take a look at an example of every—first of a call option. An investor buys a call choice to buy stock XYZ at a $50 strike price sometime inside the following three months. The stock is currently trading at $49. If the stock jumps to $60, the decision buyer can exercise the proper to purchase the stock at $50. That buyer can then immediately sell the stock for $60 for a $10 profit per share.
Other Possibilities
Alternatively, the choice buyer can simply sell the decision and pocket the profit, because the call option is value $10 per share. If the choice is trading below $50 on the time the contract expires, the choice is worthless. The decision buyer loses the upfront payment for the choice, called the premium.
Meanwhile, if an investor owns a put choice to sell XYZ at $100, and XYZ’s price falls to $80 before the choice expires, the investor will gain $20 per share, minus the fee of the premium. If the value of XYZ is above $100 at expiration, the choice is worthless and the investor loses the premium paid upfront.
Either the put buyer or the author can close out their option position to lock in a profit or loss at any time before its expiration. This is finished by buying the choice, within the case of the author, or selling the choice, within the case of the client. The put buyer can also decide to exercise the proper to sell on the strike price.
Futures
A futures contract is the duty to sell or buy an asset at a later date at an agreed-upon price. Futures contracts are a real hedge investment and are most comprehensible when considered when it comes to commodities like corn or oil. As an illustration, a farmer will probably want to lock in an appropriate crop price in case market prices fall before the crop will be delivered. The customer also desires to lock in a price to guard against a subsequent rise in prices.
Examples
Let’s display with an example. Assume two traders conform to a $7 per bushel price on a corn futures contract. If the value of corn moves as much as $9, the client of the contract makes $2 per bushel. The vendor, then again, loses out on a greater deal.
The marketplace for futures has expanded greatly beyond oil and corn. Futures will be purchased on an index just like the S&P 500, and on individual stocks in some jurisdictions. (Single-stock futures haven’t been available within the U.S. since 2020.) Buyers of a futures contract will not be required to pay the complete value of the contract up front. As a substitute, they cover a percentage of the value as an initial margin.
For instance, an oil futures contract is for 1,000 barrels of oil. An agreement to purchase an oil futures contract at $100 requires the client to risk $100,000. The customer could also be required to pay several thousand dollars up front, and should be required to extend that commitment later if oil prices subsequently drop.
Futures markets primarily serve institutional investors. These may include refiners in search of to hedge crude costs or cattle producers in search of to lock in feed prices.
Who Trades Futures?
Futures markets serve commodity producers, commodity consumers, and speculators. Futures contracts can protect buyers in addition to sellers from wide price swings within the underlying commodity.
In addition they cater to institutional in addition to retail traders in search of to make the most of expected changes in market prices for the underlying security or commodity. Financial speculators typically don’t intend to amass the underlying commodity when the contract is settled, and are prone to sell their position beforehand.
Futures trading hours may differ from stock and options markets. Normal trading hours are sometimes 8:30a.m.–3:00p.m., with electronic trading on the CME’s Globex platform overnight from 5:00p.m.–8:30a.m. CT. Some futures products trade 24-hours a day on Globex.
Key Differences
Apart from the differences noted above, there are other things that set options and futures apart. Listed below are another major differences between these two financial instruments.
Options
Because they have a tendency to be fairly complex, options contracts are inclined to be dangerous. Call and put options will be equally dangerous. When an investor buys a stock option, its risk is defined by its cost, or premium. Within the worst case scenario, the choice premium spent might be a complete loss if the choices expire worthless.
Nonetheless, selling a put option exposes the vendor to a loss potentially much larger than the premium gained from a possible decline in the worth of the shares underlying the stock option. If a put option gives the client the proper to sell the stock at $50 per share however the stock falls to $10, the vendor stays on the hook to buy the stock at $50 per share.
The chance to the client of an option is proscribed to the premium paid up front. An option’s price fluctuates based on a variety of aspects, including how far the strike price is from the underlying security’s current price, in addition to time remaining before expiration. This premium is paid to the vendor of the put option, also called the choice author.
The Option Author
The choice author is on the opposite side of the trade. Option sellers tackle more risk relative to option buyers. Since there is no such thing as a upper certain to a share price, there is no such thing as a upper limit to how much the vendor of a call option can lose on the rise within the share price. Option sellers may own the underlying stock to limit their risk.
The choice buyer in addition to the choice seller may trade out of the position in the choices market.
Futures
Options could also be dangerous, but futures will be riskier still for the person investor. Futures contracts obligate each the client and the vendor. Futures positions are marked to market each day, and, because the underlying instrument’s price moves, the client or seller can have to offer additional margin.
Futures contracts require a major capital commitment. The duty to sell or buy at a given price makes futures riskier by their nature.
Examples of Options and Futures
Options
To complicate matters, options are bought and sold on futures. But that enables for an illustration of the differences between options and futures. In this instance, one options contract for gold on the Chicago Mercantile Exchange (CME) has as its underlying asset one COMEX gold futures contract.
An options investor could have purchased a call option for a premium of $2.60 per contract with a strike price of $1,600 expiring in February 2019. The holder of this call would have had a bullish view on gold and held the proper to assume the underlying gold futures position until the choice expiration after the market close on Feb. 22, 2019.
If the value of gold rose above the strike price of $1,600, the investor would have exercised the proper to purchase the futures contract. Otherwise, the investor would have allowed the choices contract to run out. Their maximum loss was the $2.60 premium paid for the contract.
Futures
The investor may need purchased a futures contract on gold as a substitute. One futures contract has as its underlying asset 100 troy ounces of gold. This implies the client is obligated to simply accept 100 troy ounces of gold from the vendor on the delivery date laid out in the futures contract. Assuming the trader has no real interest in actually owning the gold, the contract might be sold before the delivery date or rolled over to a brand new futures contract.
As the value of gold rises or falls, the incremental gain or loss is credited to, or debited against, the investor’s account at the tip of every trading day. If the value of gold available in the market falls below the contract price the client agreed to, the futures buyer continues to be obligated to pay the vendor the upper contract price on the delivery date.