Futures vs. Options: Understanding the Key Differences
Futures and options are two financial instruments you can use to hedge against or profit on price movements of commodities and investments.
However, they have some key differences. For example, if you invest in futures, you must buy the underlying asset at a specific time in the future. On the other hand, options allow you to decide whether you want to execute the contract once it expires.
Those differences impact how investors trade futures and options.
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What Are Futures?
Futures are contracts stating that you will buy the underlying asset at a specific time regardless of its market price. This price is agreed upon when you purchase the contract.
A future contract’s underlying asset could be stocks or physical commodities — oil, corn, etc. These assets come in standardized quantities. For example, oil futures contracts are for 1,000 barrels.
When buying a futures contract, you don’t have to stake the contract’s entire value; instead, you’ll have to hold an initial margin payment — a small percentage of the total purchase value. However, contract prices fluctuate, and if you are showing significant losses, your broker might require an additional deposit.
Typically, you’ll close a position before the expiration date unless you have the physical space to hold 1,000 barrels of oil. Then, when you sell your futures contract, you’ll ideally receive enough to cover the initial margin payment with cash left over as profit.
Let’s keep going with the oil futures contract example. If you paid $100 for an oil futures contract, and the price rises to $105, you’ll get a return of $5,000 (1,000 barrels of oil x $5) when you sell it. In the meantime, you’ll only have to hold a few thousand in your brokerage account.
That’s why futures contracts can produce a substantial return on investment.
What Are Options?
There are two primary types of options trading contracts: Puts and Calls.
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How Do Put Options Work?
Put options are contracts tied to stocks. You pay a fee (premium) for the contract and gain the right to sell it at a set price (strike price) until the expiration date.
So, if the stock price decreases significantly, you can sell your put option contract to make a profit. However, you have no obligation to execute the contract, meaning if the price doesn’t drop enough for you to want to sell, you can let it expire. Your break-even point is the difference between a contract’s strike price and premium.
For example, stock AAAA trades for $500 per share. You think this stock is overvalued, so you buy a put option contract with a strike price of $450 and a 3-month expiration date. At a premium of $10 per share, your total contract price is $1,000.
In this example, your break-even point would be $440. Then, let’s say the stock drops to $400 — you’re up $40 per share. However, if it doesn’t drop below $450 during the three months, you would let the contract expire and have to eat the premium cost.
How Do Call Options Work?
Like put options, call options are tied to stock prices. However, while put options give you the right to sell at a specified price, call options allow you to buy a stock or asset at a fixed price.
Basically, it works the opposite way as a put option. Let’s look at an example to help you understand.
For the sake of our example, stock AAAA is trading for $150 per share, and you think it’s going to rise significantly soon. So, you buy a call option contract with a strike price of $170 and a 6-month expiration date. Your premium is $15 per share, totaling $1,500.
Your break-even point would be $185. If AAAA reaches $195, you would profit $10 per share ($1,000 total). If it doesn’t rise and you let the contract expire, you’ll be out your premium cost of $1,500.
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Futures: Advantages and Risks
Diversification is the primary advantage of buying futures. Because they commonly represent commodities instead of stocks, investors can capitalize on commodity price changes without buying the physical assets.
Future contracts are also highly liquid — markets are almost always open, and large-quantity trades happen often. Buying and selling are usually extremely fast. However, their biggest risk comes from one of their biggest advantages: The near 24-hour market. These markets don’t stop for anything, and global events can cause instant fluctuations.
Another risk of futures contracts is leverage. For example, if you only pay 10% of the underlying asset’s value, and the market moves against your prediction, it’s possible to lose more than you invested initially.
Options: Advantages and Risks
The most significant advantage of options is, well, having the option to walk away from a contract. You can’t lose more than your initial investment, so the losses are minimal if your prediction is way off.
Options also allow you to hedge risk against falling stock prices. For example, purchasing options against your retirement portfolio could minimize your losses if the shares you own decrease in value.
If you want to successfully trade options, you must thoroughly understand the stock market and different trading strategies. It’s extremely risky to buy options contracts without knowing how it all works, even if you invest with a trusted broker.
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Futures vs. Options: Which Investment Suits You Best?
Futures and options contracts can be profitable investments. The biggest question is, how comfortable are you at speculating market changes?
While futures can bring more significant losses, they also provide chances to quickly make up for losses and find additional profit. Options offer a little more protection against share price changes but can be more difficult to predict.
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