Options vs. Futures: A Comprehensive Guide

An options contract gives investors the right, but not the obligation, to buy or sell shares at a predetermined price anytime before the contract expires. On the other hand, a futures contract binds both the buyer and the seller to execute the transaction of the underlying asset—be it a security or a commodity—on a specific future date unless the position is closed out before the contract reaches maturity.

Both options and futures are popular financial derivatives that allow investors to speculate on market price movements or hedge against risks. However, despite some similarities, there are notable differences between options and futures contracts, especially when it comes to the rules that govern them and the risks involved for investors.

Key Takeaways

• Options and futures are both derivative contracts whose value is determined by movements in the underlying index, security, or commodity market.
• An option provides the right, but not the obligation, to buy or sell an asset within the contract’s term at a specific price.
• A futures contract mandates that the buyer purchase and the seller deliver the specified asset on a future date.
• Although both futures and options contracts can be closed before expiration, futures typically require the settlement of the asset on the designated date unless closed.

Understanding Options

Options are based on the value of an underlying asset, which could be a stock, an index future, or a commodity. With an options contract, an investor has the right—but is not obligated—to buy or sell the underlying asset at a particular price during the contract’s life. This flexibility gives options that appeal to many investors. Notably, option contracts do not convey ownership of the underlying shares unless the option is exercised.

Most stock options contracts control 100 shares with a predetermined strike price and expiration date. The price paid for an option is called the “premium.” In the United States, options trade from 9:30 am to 4:00 pm EST, coinciding with the regular stock market hours. Options exchanges close on holidays when stock markets are also closed.

Types of Options: Call and Put Options

There are two primary types of options: call options and put options. A call option grants the right to purchase a stock at a predetermined strike price before the contract expires. A put option allows the holder to sell a stock at a specific price before the expiration.

Call Option Example

Consider a scenario where an investor buys a call option on stock XYZ at a $50 strike price, valid for the next three months, while the current stock price is $49. If the stock rises to $60, the call buyer can exercise the option to buy XYZ at $50, then immediately sell the shares for $60, making a $10 profit per share.

Alternatively, the investor can sell the call option and pocket the profit from its increased value. However, if the stock’s price stays below $50 until the contract expires, the option will expire worthless, and the investor will lose the premium paid.

Put Option Example

Suppose an investor holds a put option to sell XYZ stock at $100, and XYZ’s price drops to $80 before the option’s expiration. The investor can sell the stock for $100, profiting $20 per share minus the premium cost. If XYZ stays above $100, the put option will expire worthless, and the investor will lose the premium paid.

Investors can close out their positions at any time by either selling their options (in the case of the buyer) or repurchasing them (in the case of the writer) before expiration.

Understanding Futures

A futures contract obligates both the buyer and the seller to execute the transaction of an asset at a set price on a future date. Futures are typically used as hedges, especially in commodity markets like corn or oil. For example, a farmer may use futures to lock in a crop price if market prices drop. At the same time, the buyer may want to secure a price to protect against future price increases.

Example of Futures

Consider two traders who agree to $7 per bushel for a corn futures contract. If corn prices rise to $9, the buyer will profit $2 per bushel, while the seller misses out on the higher price. This concept can be applied to many commodities, indices, and even individual stocks (though single-stock futures were discontinued in the U.S. in 2020).

Futures contracts require a percentage of the contract value as an initial margin, not the total contract price upfront. For example, if you enter into an oil futures contract at $100 per barrel for 1,000 barrels, the total contract value would be $100,000. The investor might only be required to pay a portion upfront, possibly needing additional funds if the market moves against their position.

Futures contracts are extensively used by institutional investors who want to reduce price volatility, such as oil refiners hedging crude prices or cattle producers securing feed costs.

Who Trades Futures?

Futures markets attract commodity producers, consumers looking to hedge against price fluctuations, and financial speculators. Speculators generally have no interest in acquiring the actual asset and aim to profit from price movements by trading futures contracts.

Futures markets have trading hours that are different from those of traditional stock and options markets. Regular trading hours are typically 8:30 am–3:00 pm CT, but some futures products trade 24 hours a day on platforms like CME’s Globex.

Critical Differences Between Options and Futures

While both instruments allow investors to bet on future price movements, they differ in several key areas.

Options

Options can be complex and carry significant risks. The risk for the buyer of an option is limited to the cost of the premium paid for the option. However, selling options—such as put options—expose the seller to potentially significant losses if the underlying asset’s price moves significantly against their position. For example, if a put option gives the buyer the right to sell at $50 and the stock falls to $10, the seller is still obligated to buy the stock at $50.

The premium paid for an option fluctuates based on several factors, such as the distance between the strike price and the current price and the time remaining before expiration. The option writer (the seller) takes on more risk than the buyer and may face significant losses if the underlying asset’s price rises or falls sharply.

Futures

Futures contracts tend to be riskier because they obligate both the buyer and the seller to complete the transaction. As the market price of the underlying asset moves, the contract is marked to market daily, meaning that additional margin may be required. Because of this, futures typically require more capital and carry higher risk.

Examples of Options and Futures

Options Example: Let’s look at an example involving a gold futures contract. Suppose an investor purchases a call option with a strike price of $1,600 on a gold futures contract, paying a premium of $2.60 per contract. Suppose the price of gold rises above $1,600 before the option expires. In that case, the investor can exercise the option and buy the futures contract. Otherwise, they let the option expire, and their only loss is the premium paid.

Futures Example: In contrast, purchasing a gold futures contract obligates the buyer to accept delivery of 100 troy ounces of gold on the delivery date. As gold prices fluctuate, the buyer’s account is credited or debited based on the market price’s movement relative to the contract price. Suppose the buyer does not want the gold. In that case, they must sell the contract or roll it over to another futures contract before delivery.

Conclusion

Options and futures offer investors ways to hedge against price movements or speculate on the market. However, they differ regarding obligations, risks, and how they are traded. Options provide flexibility by offering the right to execute the trade but not the obligation. At the same time, futures bind both parties to the contract terms, making them riskier for individual investors. Understanding the nuances between the two can help investors better navigate these powerful financial instruments.