An options contract gives an investor the right, but not the obligation, to buy (or sell) stock at a specific price at any time before the contract expires. In contrast, a futures contract requires a buyer to buy — and a seller to sell — the underlying security or commodity on a specified date in the future, unless the holder’s position is closed sooner.
Options and futures are two types of financial derivatives that investors use to speculate on market price changes or to hedge risk. Both options and futures allow an investor to buy an investment at a specific price on a specific date. But there are important differences in the rules governing options and futures 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 buyer the right, but not the obligation, to buy (or sell) an asset at a specified price at any time during the contract period.
- A futures contract commits the buyer to purchase a specific asset and the seller to sell and deliver that asset on a specific future date.
- Futures and options positions can be traded and closed out prior to expiration, but the parties to commodity futures contracts are typically required to make and take delivery on the settlement date.
What is the difference between options and futures?
options
Options are based on the value of an underlying stock, index futures, or commodity. An options contract gives an investor the right to buy or sell the underlying instrument at a specified price while the contract is in effect. Investors may choose not to exercise their options.
Options are financial derivatives. Option holders do not own the underlying shares or shareholder rights unless they exercise an option to purchase shares.
Options contracts on stocks typically grant the right to buy or sell 100 shares of the stock at the specified exercise price before the contract expires, and the price of the option is called the premium.
In the US, the stock options market is open from 9:30 am to 4:00 pm EST; the same as normal stock trading hours. Options exchanges are also closed on public holidays when the 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 the right to purchase a share at the exercise price before the expiration of the agreement. A put option gives the holder the right to sell a stock at a specified price.
Let’s look at an example of each – first a call option. An investor buys a call option to buy XYZ stock with an exercise price of $50 sometime within the next three months. The stock is currently trading at $49. If the stock jumps to $60, the call buyer can exercise the right to buy the stock at $50. That buyer can then immediately sell the stock for $60 for a profit of $10 per share.
Other options
Alternatively, the option buyer can simply sell the call and reap the profit since the call option is worth $10 per share. If the option is trading below $50 at the time the contract expires, the option is worthless. The call buyer loses the upfront payment for the option, called the premium.
Conversely, if an investor has a put option to sell XYZ at $100 and XYZ’s price falls to $80 before the option expires, the investor gains $20 per share, minus the cost of the premium. If the price of XYZ is above $100 at expiry, the option is worthless and the investor loses the upfront premium.
Both the put buyer and the writer can close out their option position to lock in a gain or loss at any time before expiration. This is done by buying the option in the case of the writer or selling the option in the case of the buyer. The put buyer may also choose to exercise the right to sell at the strike price.
futures
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 viewed in relation to commodities such as corn or oil. For example, a farmer may want to set an acceptable crop price in case market prices fall before the crop can be shipped. The buyer also wants to lock in a price to protect against a later price increase.
examples
Let’s demonstrate it with an example. Suppose two traders agree on a corn futures contract at a price of $7 a bushel. If corn goes up to $9, the buyer of the contract makes $2 a bushel. The seller, on the other hand, loses a better offer.
The futures market has expanded far beyond oil and corn. Futures can be bought on an index such as the S&P 500 and, in some countries, on individual stocks. (Single stock futures are no longer available in the US as of 2020.) Buyers of a futures contract do not have to pay the full value of the contract up front. Instead, they cover a percentage of the price 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 buyer to risk $100,000. The buyer may have to pay several thousand dollars upfront and later increase that obligation if oil prices later fall.
Futures markets primarily serve institutional investors. This may include refiners looking to hedge crude oil costs or livestock producers looking to lock in feed prices.
Who Trades Futures?
Futures markets serve commodity producers, commodity consumers and speculators. Futures contracts can protect both buyers and sellers from large swings in the price of the underlying commodity.
They are also aimed at institutional and retail traders looking to benefit from anticipated changes in market prices for the underlying security or commodity. Financial speculators typically do not intend to purchase the underlying commodity when the contract is settled and are likely to sell their position beforehand.
Trading hours for futures may differ from stock and options markets. Normal trading hours are often 8:30am – 3:00pm, with overnight electronic trading on the CME’s Globex platform from 5:00pm – 8:30am. CT. Some futures products are traded 24 hours a day on Globex.
main differences
Aside from the differences mentioned above, there are other things that make options and futures different. Here are some other important differences between these two financial instruments.
options
Because they tend to be quite complex, options contracts tend to be risky. Call and put options can be equally risky. When an investor buys a stock option, their risk is defined by its cost or premium. In the worst case, the option premium spent is a total loss if the options expire worthless.
However, selling a put option exposes the seller to a loss that is potentially much greater than the premium gained from a possible decline in the value of the stock option’s underlying stock. If a put option gives the buyer the right to sell the stock at $50 per share but the stock falls to $10, the seller remains on the hook to buy the stock at $50 per share.
The option buyer’s risk is limited to the premium paid up front. An option’s price fluctuates based on a number of factors, including how far the strike price is from the current price of the underlying security and the time remaining until expiry. This premium is paid to the seller of the put option, also called the option writer.
The option writer
The option writer stands on the other side of the trade. Option sellers take a higher risk compared to option buyers. Because there is no cap on a stock price, there is no cap on how much a call option seller can lose if the stock price rises. Option sellers can own the underlying stock to limit their risk.
Both the option buyer and the option seller can trade out of position in the options market.
futures
Options can be risky, but futures can be even riskier for the individual investor. Futures contracts bind both the buyer and the seller. Futures positions are marked to market daily and if the price of the underlying instrument moves, the buyer or seller may need to pay additional margin.
Futures contracts require a significant investment of capital. The obligation to sell or buy at a certain price inherently makes futures more risky.
Examples of options and futures
options
To complicate things further, options on futures are bought and sold. But this allows for an illustration of the differences between options and futures. In this example, an options contract for gold on the Chicago Mercantile Exchange (CME) has a COMEX gold futures contract as its underlying.
An options investor could have bought a call option for a premium of $2.60 per contract with a $1,600 strike expiring in February 2019. The holder of this call would have had a bullish view on gold and would have had the right to take the underlying gold futures position until the option expired after market close on February 22, 2019.
If the price 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 allowed the options contract to expire. Her maximum loss was the $2.60 premium paid for the contract.
futures
The investor may have bought a futures contract on gold instead. A futures contract has 100 troy ounces of gold as its underlying asset. This means that the buyer is obligated to take 100 troy ounces of gold from the seller on the delivery date specified in the futures contract. Assuming the trader has no interest in actually owning the gold, the contract is sold or converted into a new futures contract before the delivery date.
If the price of gold rises or falls, the additional profit or loss is credited or debited to the investor’s account at the end of each trading day. If the price of gold in the market falls below the contract price that the buyer has agreed to, the futures buyer is still obliged to pay the seller the higher contract price on the delivery date.
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