Options and futures are two common financial instruments that provide opportunities for investors. While they may seem similar at first glance to the uninitiated, there are in fact several fundamental differences between the two investing options. If you are looking at trading in either one, then you need to understand these differences to avoid making mistakes and to maximize your potential profits. Options and futures can be incorporated to your investing strategy, you just have to have a solid foundation to differentiate between the two.
What Are Options?
Options contracts are used when you are trading a financial instrument. The best examples of this would be a stock or bond. It is understood that you will pay a premium for buying an option. That means that you will pay slightly more than the price that the owner of the commodity has set after receiving bids. There are two types of options contracts. There are puts, which gives the holder of the contract the right to sell. However, with puts contracts they are not obligated to do so. Then there are calls. These contracts give the buyer the right to make a purchase at a certain price, but they are not obligated.
Let’s say the Ultra Company’s shares are trading at $60. If you want to buy call shares, then you’d have to pay $65 with the premium, with an expiry date in 30 days. If the price per share remains lower than $65, then the holder can keep the shares and the premium, and then will try to sell their calls again. If it goes over $65, then the buyer will complete the purchase and then sell them to another trader or hang onto them.
What Are Futures?
A futures contract is used to buy or sell an asset at a specific price at a specific time. In this case, the buyer must finalize the purchase when the expiration date has been reached. The seller must be able to provide the asset on that date as well. This allows you to anticipate whether the asset’s price will rise or fall during the expiration period. They can be used to hedge against market fluctuations and price changes. Future contracts can be made for a wide range of assets, like commodities, like oil and grain, currencies, and securities.
For example, a grain producer anticipates it will make one million bushels of wheat next year, and will be available to buyers in 12 months. Currently, the price is $7 per bushel. They will produce the wheat and sell it at $7, which is the current price. However, the price could change over 12 months. The wheat company could get that guaranteed price of $7, but they may choose to sell in the future if they think the price will go up. The buyer could push for a guaranteed price if they think it will go up as well. Most futures contracts expire on the third Friday of the month, as they’ve been standardized by regulators. However, there are some situations where this can be altered, so it’s important to know exactly what’s in your contract.
Here are some of the major differences between options and futures.
The structure of the contracts that you enter into is one of the key differences between options and futures. With options, the holder of the asset has the right to buy or sell an underlying asset at a predetermined right. However, they are not obligated to, and can rescind that transaction should they wish. There are two types of options: calls, which is the right to buy and sell, and puts, which is the right to sell.
Futures contracts are different. There is an obligation on the holder to buy or sell the asset at a predetermined price and time. Futures contracts are standardized in terms of quantity, quality, and delivery date. The details of the contract are set in stone, and both parties are obligated to go through with the transaction on the expiration date.
Risk and Reward Profiles
When it comes to risk and reward, options provide potentially unlimited rewards, while also exposing you to limited risk. If you buy an option you will only risk the premium that you pay for it. However, if you are selling an option, you can face a big risk if the market moves in a way that is disadvantageous for you.
Futures are wide open in the amount of risk and reward they offer for both buyers and sellers. Each is exposed to the full price movement of the underlying asset. Profits and losses can be realized on a daily basis through market fluctuations and continual trading.
For the most part, options contracts are based on various underlying assets, such as stocks, indexes, commodities, and currencies. The value and characteristics of an options contract is based on the underlying asset.
Futures contracts mostly involve commodities, like oil, rice, wheat, or gold, for example, although futures can be sold for other financial instruments like currencies and stock indexes. The contracts are standard, so the underlying asset will not affect the structure of the contract.
Options contracts have expiration dates that are at the end of the contract. They can be short-term, such as weekly or monthly, or a longer term, such as several years. Futures contracts also have expiration dates, although they are predetermined by the traders for a certain delivery period. Traders can roll their position to the next contract if they wish to maintain exposure to the underlying asset.
The pricing mechanisms between the two is also a difference. Option prices are influenced by several factors, like the underlying asset’s price, its volatility, interest rates, and time to expiration. Since futures contracts deal mostly with commodities, they are largely determined by supply and demand. The prices for futures contracts is very closely related to the price of the underlying asset.
Options and futures are both financial tools that each have unique traits and applications. By understanding the difference between the two, you can make smarter choices when you are trading and investing. When it comes to similarities between the two, they both have the potential for big returns, and they are both tools to diversify your portfolio.