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If you’re serious about active investments, you NEED to know the difference between futures and option.
Well, futures and options are totally different financial assets that require different trading strategies.
In fact, many new traders think they are the same thing, when in fact they are not.
In today’s guide, you’re going to learn everything you need to know about the differences between futures and options.
Let’s get started.
Have you ever made a promise to do something in the future?
That’s essence of a future contract.
Let’s dive in.
Let’s get the formal definition of a futures contract out of the way.
Futures contracts are a contractual agreement to either buy or sell an asset at an agreed upon price at some point in the future.
Here’s an example to illustrate how this all works.
Let’s say you agree to buy a barrel of oil from me at a price of $50 per barrel in one month’s time.
At the time of initiating this agreement, we both put down a good faith deposit of 5% of the contract value, so in this case, $2.50.
After one month passes, you buy the barrel of oil from me at a price of $50 per barrel. I give you the barrel of oil and you give me $50.
Since it’s a contractual obligation, we both are locked into the deal no matter what the market price of oil is at the time we make the transaction.
The price of oil could have skyrocketed to $100 a barrel, and I would still have to sell the oil to you at $50 per barrel because of the contract.
This means that I would be losing out on $50 because I could be selling at a higher price outside of the contract.
But you would be winning because you now have bought something worth $100 in the open market for a price of $50 using the futures contract.
The futures market is comprised of hedgers and speculators.
Hedgers: Market participants that seek to mitigate risk by taking an opposite position in the market
Speculators: Market participants that seek a return on their capital by taking risk.
Some examples of hedgers are like airline firms whose businesses depend on a stable price of oil, or banks whose businesses depend on interest rates.
What these businesses would do is either buy or sell a futures contract where they have risk to offset that risk.
At the expiration of the futures contract, these institutional market participants will actually take delivery of the underlying asset of the futures contract they are trading.
This is because it is a core part of their business.
On the other side of the market are the speculators.
Speculators are the market participants that see a return on their capital by buying and selling futures contracts for a profit.
The key difference between hedgers and speculators is that hedgers trade to reduce risk, while speculators trade to make a profit.
You can think of you and me as both speculators. However, this bucket can also include hedge funds and larger institutional investors whose business is speculating on the price of assets.
Since speculators only want to make a profit, not take delivery of the underlying asset, speculators will typically close out of the futures contract prior to expiration.
This means that if I didn’t want to sell you a barrel of oil anymore at $50, I can assign my futures contract to another market participant at the current market price of the futures contract, absolving me from any obligations.
Options contracts are very similar to futures contracts, but there are a few key characteristics that make them unique.
Let’s take a look.
Here’s the formal definition of an options contract:
Options contracts are that give the buyer a right, but not an obligation to either buy or sell the underlying asset at an agreed upon price at some point in the future.
Unlike futures, there are two types of options contracts: call options and put options.
To be clear, you can either buy or sell a call or put option.
A call option gives the contract buyer the right, but not the obligation to buy the underlying asset at an agreed upon price at a date in the future.
A put option gives the contract buyer the right, but not the obligation to sell the underlying asset at an agreed upon price at a date in the future.
Let’s walkthrough an example to see how this all works.
Let’s say you want the right, but not the obligation to buy a barrel of oil from me at a price of $50 per barrel in one month.
For this right, you have to pay me $2.50 in the form of a non-refundable options premium.
If the market price of oil goes up to $100, you would want to exercise your options contract because it would be cheaper for you to buy the barrel of oil at a cheaper price using your options contract.
Since you paid me for the right to buy a barrel of oil at $50, I am obligated to sell the barrel of oil to you at $50, even though I would be better off selling at $100 in the open market.
Let’s say instead the market price of oil is now $20.
Since you only have a right, but no obligation, you simply walk away from the deal.
Instead, you buy your barrel of oil in the open market for $20 since that’s cheaper. But you do lose out on the $2.50 option premium you paid me.
Since you walked away from the deal, I get to keep the $2.50 in option premium and I don’t have to sell the barrel of oil to you.
I just explained how options work from the option buyers perspective. It’s a little different for the options seller, so let me explain.
We saw in the previous example that buying an options contract gives you the right, but not the obligation to perform on the contract.
Well, if you sell an options contract, you have an obligation. This is because the option contract buyer can come to you at any point during the life of the option contract and demand that the terms of the contract be executed.
So, for an options seller, there is an obligation to either buy or sell the asset at the wishes of the options contract buyer.
But the options seller is not going to take on that type of risk without payment.
That’s why the options buyer has to pay a non-refundable options premium to the options seller.
So, how is this all different from futures?
Options are rights, Futures are obligations
First, options contracts are rights, but not obligations to perform on the contract terms, while futures contracts are obligations.
This means that an option contract will give you the option to buy a barrel of oil, while a futures contract will give you the obligation to buy a barrel of oil as long as you are in the contract.
But for the right to buy the asset, you have to pay a premium to the options seller.
Options decay with time, Futures do not
Because options contracts expire at a time in the future, they slowly lose their value as each day passes.
This is because as time passes, there is less time for the option contract to become valuable to the contract buyer.
Think of it this way:
A car insurance policy that covered you for the next two years would be more expensive than a car insurance policy that covered you for the next year.
Because there is smaller chance that you get into an accident in a one year contract than a two year contract.
The difference with futures contracts is that they do not decay over time.
Both futures and options are derivative contracts?
What does this mean?
Let’s find out.
Both futures and options contracts are derivative contracts.
This is because these contracts derive their value from a separate asset.
A derivative contract is a type of financial contract that alone has no value. The contract's value is dependent on the value of a separate asset.
Here’s an example:
There’s a market for crude oil. And you can certainly trade the price of raw crude oil.
But you can also create separate financial assets that depend on what the price of raw crude oil does.
Futures and options are both types of contracts that would depend on what the price of raw crude oil does.
Even crude oil ETFs and ETNs are derivative products because they depend on the price of crude oil.
Without the context of the underlying asset (crude oil), a derivative contract does not mean very much.
When you initiate a futures contract you have something called “margin”.
When you initiate an options contract you have something called “premium”.
Let’s dissect the difference between the futures margin and options premium.
When you open a futures position, you have no upfront costs.
What you have instead is something called margin.
There are two types of margin in the futures trading world: initial margin and maintenance margin.
Initial margin is the amount of money you have to set aside from your account to initiate a futures position.
You can think of the initial margin as a performance bond, or a good-faith deposit.
This deposit is to make sure you have “skin in the game” and that you will make good on the obligations of the futures contract.
Maintenance margin is the amount of money you need in your account to maintain an existing futures position.
If your account balance goes below the maintenance margin, then you’ll have something called a margin call where you will either need to liquidate the position or add more funds to your account.
The key thing to take away from futures margin is that is not a cost. It is a deposit on the purchase or sale of the underlying asset at the contract expiration.
Options contracts have something called option premium.
When a buyer wants to purchase a call or put option, the buyer has to pay a premium.
This premium is a real cost since it is non-refundable unless the option buyer sells the contract in the open market to another option buyer.
The options seller collects the option premium from the option buyer.
The option premium in this scenario is the fee paid for by the options buyer for the right, but not the obligation to either buy or sell the underlying asset at expiration.
Because there is risk for the options seller for taking on an obligation, the option buyer has to compensate the options seller accordingly.
Both futures and options have an expiration date.
Let’s go through what happens at the time of expiration for both futures and options.
At expiration, the futures contract participants are both obligated to either buy or sell the underlying asset at the agreed upon price.
Here’s an example:
I agree to sell you a barrel of oil at $50 per barrel in one month.
At expiration of the futures contract, I am obligated to sell you a barrel of oil at a price of $50, and you are obligated to buy the barrel of oil from me at $50.
If you don’t want to take delivery of the underlying asset at expiration, you can always close out your contract buy reversing your position at the market.
Options contracts at expiration act differently than futures contracts.
This is mainly because futures contracts are obligations while options contracts are rights, but not obligations.
This means the call or put option buyer has the right, but no obligation to perform on the contract terms.
The option buyer can just walk away from the deal with no consequences.
Here’s an example:
You bought a call option with the right to buy 100 shares of stock a price of $50 per share.
At expiration, the market price of the stock is $25 per share, so you would rather pay $25 in the open market instead of paying $50 under the terms of the options contract.
So, you just walk away from your contract and all you lose is the non-refundable options premium you paid to the options seller.
Futures and options seems pretty good right?
But they both have some serious financial risks if you are not aware of how both derivative contracts work.
In this chapter, I’ll lay out the financial risks that both futures and options pose on the contract participants.
Let’s get started.
When you trade futures contracts, you have unlimited risk (for both the contract buyer and the contract seller).
Why is that?
Because both parties are on the hook for performing on the contract obligations no matter the current market price of the underlying asset.
In theory, the price of the underlying asset can go down all the way to zero or all the way to infinity.
Here’s an example:
Let’s say you agree to buy a barrel of crude oil at a price of $50.
If the market price goes to zero, then the futures contract buyer is on the hook for buying something worth zero at a price of $50.
In this case, the futures buyer lost out on $50.
If on the other hand, the market price of oil goes all the way to $1,000, then the futures contract seller is on the hook for selling something worth $1,000 at a price of $50.
So, the futures contract seller lost out on $950.
Theoretically the price of crude oil has no cap, so the losses can be infinite.
The risk profile of options contracts is a little different because there is no obligation on the buyer’s side and an obligation on the sellers side.
For the option contract buyer (call or put option), the maximum potential loss is the option premium paid to the option contract seller.
This is because the option contract represents a right, but not an obligation.
So, the option contract buyer can walk away from the deal at any point without any additional loss.
On the other hand, the option contract seller is obligated to perform on the contract specifications should the option contract buyer exercise his or her contract rights.
This means that the risk for the option contract seller is theoretically unlimited.
Here’s an example:
Let’s say you sell a call option that gives the call option buyer the right to buy 100 shares of stock from you at a price of $50 per share.
If the stock price were to drop to zero, then the call option buyer would just walk away from the contract because it would be better to buy the shares at zero instead of $50 using the option contract.
However, if the price of the stock were to jump to $1,000, then the options contract seller would be on the hook. This is because the options contract buyer would want to use his or her contract rights to buy the shares of stock at a price of $50.
The option contract seller is now obligated to sell something worth $1,000 at a price of $50. This is a $950 loss for the option contract seller.
There is no cap on how high the price of the stock can go, so the risk is infinite for the options seller.
And now I’d like to hear from you:
Which seems better to you? Futures vs Options?
Or maybe you have a question about something you read.
Either way, let me know by leaving a comment below right now.
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