Futures vs Options: What's the difference? - smart asset (2023)

Futures vs Options: What's the difference? - smart asset (1)

Did you know that you can make money in the stock market when stocks are falling or in the commodity markets when prices are falling? In other words, the buy-low-sell-high approach can be reversed and still make a profit. There are actually two ways to do this: onefutures contractsYOne option. Although they are similar there is a fundamental difference and it is right in their names.

What is a futures contract?

Afutures contractsIt is a financial product in which you commit to buy or sell an underlying asset at a specified price and date. You make a profit if that contract guarantees you a better than market price at expiration (when you can buy the commodity for less than its value or sell it for more). You take a loss if the contract price is worse than the current market price.

For example, you can enter the following futures contract:

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  • On January 1st, buy 100 bushels of corn for $3.70.

On January 1, the person on the other end of this contract must buy 100 bushels of corn and sell it to you for $3.70 a bushel. If corn price is higher than your contract price on Jan 1st, take advantagepurchase of goodsfor less than it's worth. If the price of corn drops below $3.70, you lose money by having to buy bushels of corn for more than the market price.

There are two types of futures contracts: call and put.

  • call futures– A purchase contract requires you to buy the underlying asset.
  • future bet– A put contract requires you to sell the underlying asset.

Where a buy contract (as in our example above) benefits when the price goes up, a sell contract benefits when the price goes down. Suppose you enter into the following contract:

  • Sell ​​100 bushels of corn for $3.70 on January 1st.

On January 1, you must buy 100 bushels of corn at the market price and then sell it for $3.70 a bushel. If the corn price is below $3.70, you will make a profit by selling the corn for more than it is worth. If the price is above $3.70, you will take a loss.

A futures contract can be dissolved in two ways. In a cash settlement, the two traders agree to exchange the contract value only. There are no real commodity trading hands. So instead of buying or selling bushels of corn in our examples, you would simply collect or pay the difference between the contract value and current market prices. In a physical deal, merchants trade physical goods. You would literally buy 100 bushels of corn and provide an address where you can accept delivery.

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What is an option contract?

Futures vs Options: What's the difference? - smart asset (2)

Aoption contractIt is structured in the same way as a futures contract, with one crucial difference. With options, you agree to trade an underlying asset at a specified price and date. You can settle this with cash settlement or physical settlement, so both parties can decide if they are interested in pure financial speculation or if they are actually trading in the commodities market. And you can take a buy or sell position, depending on whether you think the asset's price is going to go up or down.

The difference is that, as the name suggests, the options contract is optional. When the contract expires, you can decide whether you want to continue with it or pass your option. If you pass, nothing happens. The contract expires without being fulfilled; You only have the money you spent to complete the contract. When executing the contract, you can exchange physical goods or exchange payments.

If a futures contract creates a bilateral obligation (both parties to the contract must fulfill their part of the deal), an options contract creates a unilateral obligation (only the person who entered into the contract is necessarily bound by it).

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Options vs futures: how to choose

Let's put it this way: options are good business. You exercise the contract when you earn money from it. They leave any contract that doesn't. In fact, they specifically eliminate the biggest single risk of futures trading: actual and potentially unlimited losses.

When a futures contract expires with no profit, you actually owe money. See our example above. Suppose you buy a contract to sell 100,000 bushels of corn at $3.70 on January 1st, a modest contract by professional trader standards.

On January 1st, the price of corn dropped to $3.40. The difference between contract value and market value is 100,000 times $0.30 or $30,000. In fact, you owe that $30,000. This differs from traditional investments like stocks and bonds, where you can never lose more than your initial investment amount.

Options protect you from this risk of loss. If our example above were an options contract, on January 1st you would see that you had an unprofitable position and simply let the contract expire without exercising it.

However, this makes options contracts much more expensive than futures contracts.

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With most futures contracts, all you need to do is deposit some money into your brokerage account to show that you can cover potential losses. Otherwise, the actual contract price is little more than minimal transaction costs. However, options contracts charge what is called a "premium". This is a price the trader charges to sell you the contract.

Contracts that are more likely to expire profitably require higher premiums. If the contract ends without profitability, you lose that money. If you make money on the option, your earnings will be the difference between the premiums and what the contract paid for.

Ultimately, the difference between futures and options comes down to this: futures are high risk, high reward. Options reduce your risk to a known loss. You can never lose more than your contract premiums, but your profits will always be reduced by this premium price.

the end result

Futures vs Options: What's the difference? - smart asset (3)Futures are contracts where you agree to buy or sell an underlying asset at a specific price on a specific date. When the contract expires, you make money or lose money, depending on whether the contract expires profitably. Options is also a contract to buy and sell an underlying asset at a specified price on a specified date, but gives the option to exit if the position is not profitable.

Tips on using options and futures

  • Options and futures trading can be complex, so consider working with a financial advisor if you want to incorporate them into your investment plan.Ferramenta gratuita SmartAssetconnects you with financial advisors near you in five minutes. When you're ready for local advisors to help you reach your financial goals,Start now.
  • one is thisasset allocation toolhow to balance your risk tolerance with different combinations of large-cap, mid-cap, and small-cap stocks.

Image credits: ©iStock.com/Igor Kutyaev, ©iStock.com/alexsl, ©iStock.com/Laurence Dutton

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eric schiedEric Reed is a freelance journalist specializing in business, politics and global issues, with extensive coverage of finance and personal finance. He has made contributions to outlets such as The Street, CNBC, Glassdoor and Consumer Reports. With a focus on the human impact of abstract themes, Eric's work emphasizes analytical journalism that helps readers better understand their world and their money. It reported from over a dozen countries with date lines like São Paulo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former lawyer before becoming a journalist, Eric worked in white collar crime and securities litigation with a pro bono expertise in human trafficking issues. He is a graduate of the University of Michigan School of Law and can be found rooting for his Wolverines every Saturday in the fall.


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