Futures and options contracts are both derivatives—they allow you to speculate on the future value of an underlying asset. But they work differently, and understanding the difference is crucial if you want to make money from them.
In this article, we’ll cover the basics of futures and options, including key differences and examples.
Commodities - Commodities are goods that have full or substantial fungibility—that is, the market treats instances of them as equivalent and interchangeable, regardless of who produced them.
Derivatives - A contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate and is often simply called the "underlying."
Hedge - Financial hedging refers to the management of adverse price movements in a physical transaction through the use of financial derivatives.
Strike Price - An option’s strike price is the fixed amount at which its owner can buy or sell an asset (such as stock options) to the person who issued it. This may be set in relation to current spot prices.
Option writer - The seller of an option.
Option buyer - The buyer of an option.
Premium - A premium is an amount paid above and beyond the intrinsic value—or price, in economic terms
What Are Options Contracts?
An options contract gives you the right, but not the obligation, to buy or sell a specified quantity of an underlying security for a fixed price on or before a specified date. The buyer of an option is said to have purchased it is an ‘option holder’; the writer of an option is said to have sold it and is an ‘option writer’.
The buyer pays a fee called a premium for this right, while the seller receives the premium.
How Options Contracts Derive Their Value
An option’s value is made up of two parts: intrinsic value and time value. The intrinsic value is the difference between the strike price and the stock’s market price, while time value is the portion of an option’s premium that is attributable to the amount of time remaining until the expiration of the option contract.
Time value decreases as you reach the contract’s expiration date. This is called time decay.
Who Is Involved In Options?
When you think about options, it’s important to understand that there are two distinct parties involved in every transaction: the seller and the buyer.
The seller of the option is known as the option writer. The buyer is called the option buyer.
Call options are a type of derivative that gives the holder the right to buy a stock at a specific price before the agreement expires. The strike price is the price at which the option can be exercised, and it must be less than or equal to the underlying asset’s current market price.
For example, let’s say you purchased a call option in the XYZ index valid for the next nine months. At the time of your purchase, it was trading at $150USD strike price. Six months later the share has skyrocketed to $230USD. As a call option holder, you would have the right to purchase the index share at the strike price of $150USD.
Put options are another type of derivative that gives the holder the right to sell a stock at a specific price before the agreement expires. The strike price for put options has to be greater than or equal to the underlying asset’s current market price.
If an investor owns a put option to sell XYZ at $230USD and XYZ’s price falls below this level before the option expires, they will gain $125USD per share less, minus any premium paid.
If the price of XYZ is above $230USD at expiration, the option will expire worthless, and the investor loses what they paid upfront, including the premium paid.
Do options contracts allow me to own the underlying stock or index?
No, options do not allow you to own the underlying asset. Options contracts give you the right, not the obligation to purchase the underlying asset.
What Are Futures?
Futures contracts are agreements to sell or buy an asset at a later date at an agreed-upon price. They are most often considered in terms of commodities like corn or oil futures contracts, but can be used for anything from stocks to currencies.
Because the seller is obligated to deliver the asset by the future date, this contract helps manage cash flow by locking in prices for future sales or purchases.
Who Is Involved In Futures?
Futures trading is a popular way for institutional investors to protect themselves against price swings in the underlying commodity.
Futures contracts are a way for buyers and sellers of commodities to lock in the price of an asset. They’re used by various investors, including institutional investors and commodity producers, commodity consumers, and speculators.
Institutional investors are primarily buying futures as a way to hedge costs. Refiners may buy futures contracts on crude oil when they don’t have enough cash flow to pay for the oil they need to keep operating. This allows them to buy oil at the specified price—even if prices rise or fall before they’ve paid for it.
Farmers are another group who often buy futures contracts. Farmers will use these contracts to lock in prices for their crops before they harvest them so they know how much money they’ll make off their crops. This helps them plan their business operations and protect themselves from wide swings in price that might occur during harvest season when supply is low, and demand is high.
Commodity producers, commodity consumers, and speculators can also buy futures contracts as a way of speculating on price movements.
Speculators might purchase futures contracts when they believe the underlying commodity’s price will fluctuate at some point in the future—and then sell them before the future date.
Which Is Riskier: Futures Or Options?
Futures and options contracts are used as a method of mitigating risk. They can be used to minimize risk through hedging strategies. Futures also help mitigate risk. By locking in a price for which you are guaranteed to be able to buy or sell a particular asset, companies can eliminate unexpected expenses or losses.
However, these strategies don’t exclusively serve as hedges and pose risks to investors in the same way all investments do.
Options Contract Risk
Call and put options are equally risky.
The seller takes on more risk than the buyer because they must purchase or sell an asset if an option is exercised against them by its owner.
Buyer risk is limited to the premium paid for an option contract.
Futures Contract Risks
Futures contracts obligate both the buyer and seller to fulfill their side of the contract at some point in the near future. If you’re a buyer, you’re obligated to buy a certain amount of an underlying instrument at a given price; if you’re a seller, you’re obligated to sell that same amount at that same price.
Futures positions are marked to market daily, which means that as the underlying instrument’s price moves, the buyer or seller may have to provide additional margin (security) to maintain their position. This can be risky if your position loses money.
Futures contracts require a significant capital commitment—the obligation to sell or buy at a given price makes them riskier by nature. This is also why they’re more popular with institutional investors.
These investment products are similar to stock options and index options but are bought and sold on futures.
Options on futures are contracts that represent the right, not the obligation, to buy or sell particular underlying futures at a specified price on or before the specified expiration date.
How Futures Options Work
Options are a great way to get into the futures market without having to tie up much cash up front.
For example, say you want to invest in an index future and you’ll need $6,300 to do so. If you buy and hold the index outright, then that’s the amount of money that’s tied up in the investment.
But if you buy an option on the same index instead, you’ll only have to pay about $850 plus commissions and fees. That means that with options, while the leverage is the same, the amount of cash used may be significantly greater than in the futures contract itself. Since you’re investing less, you also have the potential to increase profit margins significantly.
These types of investments are complicated. They have a ton of moving parts, and their price movements are not uniform.
Each futures option represents an agreement to buy or sell a certain amount of an underlying commodity, index, or bond at a set price in the future.
The price of each futures contract depends on the amount of the commodity or asset being traded and the current market value of that commodity or asset. So if you own a futures option on 10 barrels of oil that are currently trading at $50 per barrel, and one month later, they increase in value to $55 per barrel, your option will now be worth more—but it’s not always clear exactly how much more.
Unlike with stocks, where a $1 increase in price represents a $1 increase in value, price changes in futures aren’t uniform and are highly dependent on the amount of the commodity defined by each futures contract.
How Do I Invest In Futures and Options?
Investing In Options
Now that you know the basics of how to invest in futures and options, you can get started!
The first step is to open an account with a broker. You’ll need to choose which broker best fits your needs based on products offered, fees, and other factors. Once you’ve found one that’s right for you, open an account and fund it with enough money to make your trades.
Next, pick which options you want to buy or sell. For example: if you think the price of sugar will rise over the next month, you could buy a call option on sugar futures; if you think it will fall, then sell a put option instead.
Finally, predict whether or not the stock price will be above or below the strike price at expiration time.
Investing In Futures
Investing in futures is a bit different than options because there are more steps involved.
First, you’ll need to request and be granted approval to begin trading. This is a process that may take a few days, so make sure you plan ahead!
Once you’re approved, you can start trading. Most futures contracts are traded through centralized exchanges like the Chicago Board of Trade and the Chicago Mercantile Exchange (CME). The majority of futures contracts start trading Sunday at 6 p.m. Eastern time and close on Friday afternoon between 4:30 and 5 p.m. Eastern.
Investing in derivatives is complicated and risky, but with Hedgeful, you can invest like the pros. Hedgeful allows you to invest in derivatives like options and futures to create the ideal portfolio balance for your unique risk tolerance and appetite for volatility. You’ll get impactful institutional investment advice designed for retail investors so you can feel confident about making sound, informed decisions.