An options contract gives the investor the right, but not the obligation, to buy (or sell) stock at a specified price at any time before the expiration of the contract. In contrast, a futures contract requires a buyer to buy and a seller to sell the underlying security or commodity at a selected future date, unless the holder's position is previously closed out.
Options and futures are two types of economic derivatives that allow investors to take a position on changes in market prices or hedge risk. All options and futures allow an investor to purchase an investment at a selected price on a selected date. But there are important differences in the fundamentals of futures and options contracts and the risks they pose to investors.
The central theses
- Options and futures are two types of derivative contracts that derive their value from market movements in the underlying index, security or commodity.
- An option gives the customer the right, but not the obligation, to buy (or sell) an asset at a specified price at any time during the term of the contract.
- A futures contract commits the customer to buy a selected asset and the seller to sell and deliver that asset at a selected future date.
- Futures and options positions can also be traded and closed prior to expiration; however, parties to commodity futures contracts generally must make and take delivery on the settlement date.
What is the difference between options and futures?
Options are based on the value of an underlying stock, index or commodity futures. An options contract gives the investor the right to buy or sell the underlying instrument at a chosen price for the duration of the contract. Investors can choose not to exercise their options.
Options are financial derivatives. Option holders do not own the underlying shares or enjoy any shareholder rights unless they exercise an option to purchase shares.
Stock option contracts generally provide the right to buy or sell 100 shares at the required strike price before the contract expires, and the amount of the option is called the premium.
In the United States, the stock options market is open from 9:30 am to 4:00 pm EST; identical to the stock exchange's normal trading hours. Options exchanges are also closed on holidays when exchanges are closed.
Types of options: call and put options
There are only two types of options: call options and put options. A call option gives you the right to buy a share at the strike price before the contract expires. A put option gives the holder the right to sell a share at a specified price.
Let's look at an example of each call option. An investor buys a call option to buy stock in XYZ sometime within the next three months at a strike price of $50. The stock is currently trading at $49. If the stock rises to $60, the decision buyer can exercise the right to buy the stock for $50. That buyer can immediately sell the stock for $60 at a profit of $10 per share.
Alternatively, the selected buyer can simply sell the decision and take the profit as the call option is valued at $10 per share. If the election is trading below $50 at the time the contract expires, the election is worth nothing. The decision buyer forfeits the initial payment for the choice, called the premium.
On the other hand, if an investor has a put option to sell XYZ at $100 and the price of XYZ drops to $80 before the option expires, the investor will earn $20 per share, minus the premium rate. If the value of XYZ is greater than $100 at expiration, the election will be worthless and the investor will lose the initial prize.
Both the put option buyer and the writer can close out their option position at any time before expiration for profit or loss. This ends up buying the selection in the case of the author or selling the selection in the case of the customer. The put option buyer may also elect to exercise the put option right at the strike price.
A futures contract is a commitment to sell or buy an asset at a future date at an agreed price. Futures contracts are a true hedging asset and are most understandable when it comes to commodities like corn or oil. To illustrate, a farmer will likely want to set a reasonable crop price in case market prices drop before the crop is delivered. The customer also wants to set a price to protect against a later price increase.
Let's illustrate this with an example. Suppose two traders maintain a price of $7 a bushel for a corn futures contract. If the value of corn rises to $9, the contract customer earns $2 per bushel. Seller loses a bigger deal again.
The futures market has expanded far beyond oil and corn. Futures are bought on an index such as the S&P 500 and, in some countries, on individual stocks. (Individual stock futures are no longer available in the US as of 2020.) Buyers of a futures contract are not required to prepay the full amount of the contract. Instead, they cap a percentage of the amount as an initial margin.
For example, an oil futures contract is for 1,000 barrels of oil. An agreement to buy an oil futures contract at $100 requires the customer to risk $100,000. The customer may also be required to pay several thousand dollars upfront and then extend that obligation if oil prices fall later.
Futures markets primarily cater to institutional investors. This could include refineries trying to cover the cost of crude oil or livestock producers trying to keep feed prices low.
Who trades futures?
Futures markets serve commodity producers, commodity consumers and speculators. In addition to sellers, futures contracts can also protect buyers from large price swings in the underlying commodity.
In addition, they are intended for institutional and retail traders who want to take full advantage of expected changes in market prices of the underlying security or commodity. Financial speculators typically do not intend to accumulate the underlying commodity when the contract is settled and tend to sell their position early.
Trading hours for futures may differ from those for stock and options markets. Sometimes normal trading hours are from 8:30 am to 5:30 pm. m. at 3:00 pm, with electronic trading on CME's Globex platform overnight, starting at 5:00 pm. m. at 8:30 am. CONECTICUT. Some futures products are traded 24 hours a day on Globex.
In addition to the above differences, there are other things that make options and futures different. Below are other important differences between these two financial instruments.
Because they are quite complex, options contracts tend to be dangerous. Call and put options are equally dangerous. When an investor buys a stock option, his risk is defined by its cost or premium. In the worst case, the spent election prize can be a complete loss, as the election expires worthless.
However, the sale of a put option exposes the seller to a loss that may be much greater than the premium earned by a possible drop in the value of the stock underlying the call option. If a put gives the customer the right to sell the shares at $50 a share, but the shares fall to $10, the seller is still obligated to buy the shares at $50 a share.
The opportunity for the customer of an option is denied the premium paid in advance. The price of an option fluctuates based on a number of factors, including the distance between the strike price and the current price of the underlying security and the time remaining until expiration. This premium is paid to the seller of the put option, also known as the caller.
The author of the option
The author of choice is on the other side of the trade. Option sellers take on higher risk compared to option buyers. Since there is no safe upper limit to the price of a stock, there is also no upper limit to how much a call option seller can lose if the stock price goes up. Option sellers can own the underlying stock to limit their risk.
The chosen buyer can trade the position in the chosen market in addition to the chosen seller.
Options can also be dangerous, but futures are even riskier for the retail investor. Futures contracts are binding on both the buyer and the seller. Futures positions are marked to market on a daily basis, and as the price of the underlying instrument moves, the customer or seller may be required to pay additional margin.
Futures contracts require a large capital investment. The obligation to buy or sell at a certain price naturally makes futures riskier.
Examples of options and futures
To further complicate matters, options on futures are bought and sold. But it does allow for an illustration of the differences between options and futures. In this case, a gold options contract on the Chicago Mercantile Exchange (CME) is underlying a COMEX gold futures contract.
An options trader could have purchased a call at 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 a bullish view on gold and would have the right to accept the underlying gold futures position until the survey expires after market close on February 22, 2019.
If the value of gold had risen above the $1,600 strike price, the investor would have exercised the right to buy the futures contract. Otherwise, the investor would have let the option contract expire. His maximum loss was the $2.60 premium paid for the contract.
The investor may need to purchase a gold futures contract as a substitute. A futures contract has 100 troy ounces of gold as the underlying asset. This means that the customer must simply accept 100 troy ounces of gold from the seller on the delivery date specified in the futures contract. Assuming the trader has no real interest in owning the gold, the contract can either be sold before the delivery date or converted into a new futures contract.
As the value of gold rises or falls, the incremental profit or loss is credited or debited from the investor's account at the end of each trading day. If the value of gold available on the market falls below the contract price agreed with the customer, the futures buyer remains obligated to pay the seller the higher contract price on the delivery date.