Distinguishing Between Options and Futures: An Exploration of Their Variances

An options contract grants an investor the right, though not the obligation, to purchase or sell shares at a predetermined price before the contract’s expiry. On the other hand, a futures contract mandates a buyer to acquire the underlying asset or commodity, and a seller to sell it, on a specific future date unless the position is closed earlier.

Options and futures, both being financial derivatives, provide investors with tools to speculate on market movements or hedge risks. While both instruments enable investors to secure an investment at a set price by a specific date, there are key disparities in the regulations governing options and futures contracts, as well as the risks they entail.

Options

Options, whether linked to an underlying stock, index future, or commodity, offer investors the right to buy or sell the underlying asset at a predetermined price during the contract’s term. Investors retain the choice of whether or not to exercise these options.

Options are financial derivatives, whereby option holders do not possess the actual shares or shareholder rights unless they decide to exercise their option to acquire stock.

Typically, options contracts for stocks provide the right to buy or sell 100 shares of a stock at a specified strike price before the contract expiration, with the option price known as the premium.

In the United States, the equity options market operates from 9:30 am to 4:00 pm EST, mirroring regular stock trading hours, also observing holidays when stock exchanges are closed.

Types of Options: Call and Put Options

Options are limited to two varieties: Call options and put options. A call option grants the right to buy a stock at the strike price before the agreement expires, whereas a put option provides the holder with the right to sell a stock at a designated price.

Consider an example for each scenario, starting with a call option. An investor purchases a call option to buy stock XYZ at a $50 strike price within the next three months. If the stock price jumps to $60, the call buyer can exercise the right to buy at $50 and sell immediately at $60 for a $10 profit per share.

Other Possibilities

Alternatively, the option buyer can sell the call for a profit if its value is above $50 upon contract expiration, causing it to be worthless. On the flip side, owning a put option to sell XYZ at $100 can yield a profit if the price falls to $80 before expiry.

Closing out an option position can secure a profit or minimize losses before expiration, achieved by buying (for writers) or selling (for buyers) the option. The put buyer can also opt to exercise the right to sell at the strike price.

Futures

Futures contracts entail the obligation to buy or sell an asset at a future date at an agreed-upon price. Primarily used to hedge investments, futures contracts are best understood concerning commodities like corn or oil.

Examples

For instance, in a corn futures contract priced at $7 per bushel, a price increase to $9 benefits the buyer but results in a loss for the seller.

Futures have expanded beyond commodities like oil and corn to include indices such as the S&P 500 and some individual stocks. Buyers can initiate futures contracts by paying an initial margin rather than the full value upfront.

Evidently, the futures market predominantly caters to institutional investors seeking to hedge their exposure to various markets.

Who Trades Futures?

Futures markets serve multiple entities, including producers, consumers, and speculators, offering protection against fluctuations in commodity prices.

These markets also accommodate institutional and retail traders looking to capitalize on market price changes for assets. Financial speculators often exit positions before settlement, emphasizing profit over physical possession of the underlying asset.

Trading hours for futures may diverge from those of stock and options markets, with potential 24-hour trading on specific products.

Key Differences

Options

Options contracts, known for their complexity, pose risks for investors. Both call and put options carry inherent risks, with losses potentially exceeding the premium paid if options expire worthless.

Specifically, selling put options can expose sellers to substantial losses if the underlying stock value decreases significantly.

The risk to option buyers is capped at the premium paid, affected by factors like the strike price’s proximity to the current security price and time until expiration. This premium compensates the option writer, i.e., the seller.

The Option Writer

Option writers assume a higher risk than buyers since there is no predetermined cap on potential losses. These sellers may hold the underlying stock to mitigate their risk exposure.

Both option buyers and sellers can exit their positions in the options market.

Futures

While options come with risks, futures can be riskier, demanding obligations from both parties. Daily marking-to-market of futures positions requires additional margin as prices fluctuate, reflecting the inherent risk in futures contracts.

Futures contracts necessitate a substantial capital commitment, brimming with risk due to the compulsory buy/sell obligation at a predetermined price.

Examples of Options and Futures

Options

Options trading intertwines with futures, offering illustrative differences. Consider an options contract for gold, where one COMEX gold futures contract serves as the underlying asset.

Imagine buying a call option for gold at $1,600 with a premium of $2.60, setting to expire in February 2019. If the gold price surpasses $1,600, the investor can exercise the call option; otherwise, they face a maximum loss of the premium.

Futures

Alternatively, investing in a gold futures contract obligates the buyer to receive 100 troy ounces of gold on the delivery date. The investor may close or roll over the position rather than take physical possession of gold.

At the market’s end each day, any gains or losses on the gold price accrue to the investor. Should the market price fall below the agreed contract price, the buyer remains obligated to pay the higher contract price at delivery.