Options and futures are both financial products that are derivatives of the underlying assets they are pinned to. They can be used to trade for profit or to hedge against fluctuations in the asset they are investing in. Both options and futures are difficult financial products to master, however, are both very lucrative to traders looking to grow their portfolios.
So what’s the difference?
An option gives investors the right, but not the obligation to buy or sell shares of an asset at a specific time and price, as long as the transaction occurs before the contract’s expiration date. However, a future is different as there is a contractual obligation to buy or sell the asset at a specific time and date.
Options exist in two kinds: call and put options. A call option allows traders to buy an asset at a strike price before or at the expiration date. A trader would purchase a call option when he expects the price of the security to increase more than the strike price of the option contract. In this case, he or she would take profits of the difference between the security price and the strike price, after subtracting the premium purchased for the option.
Conversely, a trader would purchase a put option when he or she expects the price of the security to fall lower than the strike price of the option contract. In this case, the trader would take the profits of the difference between the strike price and the price of the security, after taking into account the option premium.
With options, the risk to those purchasing call/put options is the loss of the option premium if the option is out-of-money by the time the contract expires. However, when one writes an option (sells) the risk is theoretically unlimited.
Futures are most often used as a hedging instrument. They also are used for trading stock indices or commodities, bonds, as well as currencies. The futures market has expanded significantly since its inception, and now offers products such as E-Micro and E-Mini contracts to open futures trading up to retail investors with smaller portfolios.
When a trader purchases a futures contract, they are not required to pay for the contract upfront, and rather pay a certain percentage of the contract, known as a margin. This margin is used as a security deposit for the clearinghouses responsible for the transaction, in the event that the trader is unable to fund their obligation at expiration.
Risk of Futures vs. Options
Trading options and futures are difficult and risky for new individual investors. Futures are typically less complex than options for various reasons.
Managing the margins – futures
Futures prices may fluctuate greatly, which could result in a trader having to deposit more funds into their account to maintain a margin balance. With greater fluctuations, traders may not be able to support the account margins.
Managing the margins – options
Unless one sells an option naked, the most that they can lose is the option premium paid. When trading futures, the market may swing drastically, which could result in margin calls and significant losses. Conversely, with options, the most one can lose is the option premium, so maintenance of margin is not a typical issue.
Both futures and options are great ways to enhance one’s trading strategies, and one looking to maximize their potential for profit should do more research to learn about the benefits of utilizing these instruments.
Next article: Clearinghouses and Trading