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Futures vs. Options – What is the difference between them?

Futures vs options
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To many beginners, futures and options may sound like yet another sophisticated creation of financial engineering, aimed to provide investors with new and exotic profit opportunities. The truth is that they were invented with a real use-case and have been around since 1864 in the case of futures and 1971 in the case of options. Today, they are a market much bigger than the equities one and are enjoyed by retail and institutional investors. In the next lines, we will find out what is the difference between futures vs options.

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What are futures and options?

Futures and options are both derivative instruments designed to provide their holders with a flexible hedging and potentially-profitable tool. Think of futures contracts as a guarantee and the options contracts as a voluntary guarantee.

A futures contract gives the investor the right and the obligation to buy or sell an underlying asset (stocks, bonds, commodities, etc.) at a pre-determined date and price.

Options, on the other hand, give the right to buy/sell the underlying asset but aren’t obligatory. This means the holder of the options contract can choose whether to exercise it or not. His decision depends on the terms and whether they work for him in the current market situation.

To make it clearer, here is an example. The futures contract, in its current form, evolved back in the days when farmers (sellers) faced the uncertainty of whether they would find buyers for their production once it is harvested.

Buyers (owners of bakeries, for example), on the other hand, had to find ways to secure their future deliveries, so there was no risk of disruption to their operations.

To overcome this, the sellers and the buyers used a futures contract to strike a future exchange of a commodity for cash. Both sides agreed on a price, and the farmer had to deliver the dealer the commodity (let’s say 10 000 bushels of wheat) at the pre-agreed date.

What was the benefit? By using futures contracts, the farmer gets a stable price for his wheat (without knowing what year he is expecting and how it would affect the market price), while the dealer secures his delivery and estimates his business costs in advance.

How Options Work

Options contracts are based on the value of the underlying asset, be it a stock, a commodity, an index, etc. Options’ owners have the opportunity to trade the given asset at a fixed price before the options contract expires. However, they aren’t obligated to do so – if they don’t want, they don’t have to trade.

Options contracts don’t represent ownership until they are exercised.

To purchase an option, the individual has to pay a premium upfront. The premium reflects a certain quantity of the underlying asset (usually a percentage). The premium represents the strike price of the asset. Or, in other words – the rate at which it can be bought or sold until the expiration date.

There are two types of options contracts – call and put options. Call options represent an offer to buy an asset, while put options represent an offer to sell an asset.
To understand it better, let’s take a look at the following example.

Joe decides to buy a call option on AAPL to buy it at a strike price of $250 within the next three months. At the given moment, the instrument trades at $245. If the share price jumps above $250 during the next three months, he can buy it for a price of $250, sell it immediately, and make a profit by pocketing the difference. On the other hand, if the share price drops below the strike price of $250, Joe can miss out on exercising the option. All he will lose in this scenario is the premium he paid initially.

How Futures Work

Futures contracts are obligations to buy or sell the underlying asset at a pre-determined future date and a price, determined at the given moment.

Having the chance to lock a price in advance allows businesses to hedge against massive price swings in the upcoming future.

When buying a futures contract, the buyer isn’t required to pay the full amount upfront. Instead, he pays a percentage, which is called an initial margin.

Both institutional and retail investors use Futures contracts. Institutional investors like airline companies, for example, can buy futures on oil to ensure a fixed price in advance. Retail investors, on the other hand, buy futures contracts only with speculative purposes to capitalize on price movements. They don’t have any real intention to take possession of the underlying asset.

Here is an example of how it works in practice. Let’s say two parties agree to trade petrol for $35 per barrel. If the price of the crude oil goes up to $40, then the buyer captures a $5 profit. If, on the other hand, the price goes down to $30, then the $5 profit is for the seller.

Today, the futures market covers more than just commodities. There are futures on stocks, bonds, indices, and even options.

What is the difference between futures vs options?

Now let’s deep-dive in the topic and explore the difference between futures vs options. Unlike stocks trading, which is a relatively simple and straightforward process, options and futures provide a whole new universe of trading opportunities. It is worth noting, though, that trading these assets often is a bit more complicated.

That is because, although futures and options are commonly used in the investment world, not everyone is familiar with their characteristics and key details. Before taking a look at each asset type and what is the difference between futures vs options, let’s take a moment to look at their similarities first.

First of all, we should start by saying that both are exchange-traded derivative instruments. This means they derive their value from the performance of the underlying asset.

They are traded on exchanges and trading venues globally with daily settlement (options can be traded OTC as well).

Both asset classes may cover underlying assets such as FX, bonds, stocks, commodities, and more.

“The price of a commodity will never go to zero. When you invest in commodities futures, you’re not buying a piece of paper that says you own an intangible piece of a company that can go bankrupt.”
– Jim Rogers

Aside from the fact that both instruments provide some sort of flexibility and freedom to the investor, the other main similarity is how suitable they are for leverage trading. That is the reason why they are among the favorite asset classes of advanced traders, speculators, prop shops, high-frequency trading firms, and professional portfolio managers.

This, however, makes them quite tricky investment instruments for beginners. Without the proper risk management strategy in place, newbies can lose a lot of money trading futures and options.

Another fundamental similarity of options and futures is their suitability for hedging purposes. Investors often use them to protect themselves from market, sector, or other types of risks. To trade options and futures, one should have an active margin account.

Although sharing some similarities, in reality, options and futures are very different from each other. To clear things out, let’s take a look at the top 5 factors that make the difference between futures vs options:

1. Level of Risk and Profit Potentials

The first and most notable difference between futures vs options is related to the level of risk associated with both instruments.

With futures trading, the level of risk is very high, especially when trading on leverage. This means investors without proper exit and risk management strategies (stop-loss orders, etc.), may experience losses of times their portfolios.

Here is an example – futures contracts trading usually allows the trader to take advantage of up to 95% margin (sometimes even more). This means that he will lose all his portfolio in case the underlying asset moves only by 5% in the opposite direction.

With options trading, on the other hand, the risk is restricted to the amount of premium you pay. There is no way the investor loses more afterward. He is also free not to exercise the option if the terms have become unfavorable. So, in this situation, the worst-case scenario is that the options expire as worthless, and the investor loses the initial amount he paid.

Also, another key risk factor is that options’ price fluctuations aren’t as aggressive as those of futures. With the latter, if you are trading on a margin, similar as the one, mentioned before, just a single price swing may wipe out your portfolio. With options, as long as the market reaches your target, you are safe. Even in case they don’t, all you lose is your premium.

We should not forget liquidity as well. Futures markets are one of the most liquid ones worldwide. The lack of slippage is thanks to the variety of big-money firms taking part in futures trading on a daily basis.

HFT companies, hedge funds, wealth management firms, and others generate a considerable trading volume in the futures market every day. Options, on the other hand, don’t enjoy such interest. Even the most liquid ones make it pretty hard to unload big positions quickly and without affecting the market.

Both the futures and the options contracts are similar to each other in terms of having no restriction on the amount of potential profit. Regarding the case of options sellers, though, the potential profit is limited to the amount of the premium the buyer paid.

2. The Buyers’ and Sellers’ Obligations

This is another key difference between futures vs options. Let’s start with the buyers’ obligation first. With futures, the buyer is obligated to honor the contract on the pre-agreed date and is basically locked into it. With options, the buyer of the contract has the freedom to decide whether or not to execute it.

The sellers’ obligation with futures contracts is no different – the seller is obliged to execute the contract. With options, on the other hand, the seller is dependable on the buyer’s choice – if he decides to buy the option, the seller has no choice but to sell it, and vice-versa. So, here, the seller bears a higher risk when compared to the buyer.

3. The Payment Scheme and the Execution Schedule

With futures contracts, the investor doesn’t have to make any payments in advance, except the accompanying commission.

Options traders, on the other hand, have to pay a premium in advance. The premium is a small percentage of the entire amount.

That is also the reason why both types of assets are so different in terms of risk. While with futures contracts, the trader may have to make a hefty payment afterward, with options, all the payments are capped to the amount paid initially.

Also, you can only execute futures contracts can on the pre-determined date. With options, things are quite different. First of all, we should mention that there are two types of options contracts – American and European.

American types are the more common and widely spread options contracts. They allow allow execution on any day before the expiry date. The European types, on the other hand, are similar to futures contracts and can be executed only on the expiration date.

It is worth noting, though, that options lose value with every day that gets them closer to the expiration date. This might be both a positive and a negative, depending on which side of the trade you are. Since most options end up expiring worthless, sellers usually get better odds than buyers. Futures, on the other hand, don’t suffer from time decay.

4. The Contract Specifics

We can also find a difference between futures vs options in their contract terms and specifications. The most notable differences are in the minimum price fluctuation, which for options is always lower.

Futures and options can also be different in the trading hours, the trading termination period, and the listed contracts.

Here is an example of a futures and options contract on one and the same commodity – (corn), issued by the CME Group:

Corn Futures

Product CodeZC
Contract Unit5,000 bushels
Price QuotationCents per bushel
Minimum Price Fluctuation$12.50 or 1/4 of a cent (0.0025) per bushel

 

TAS: Zero or +/- 4 ticks in the minimum tick increment of the outright

Trading HoursFrom Sunday to Friday between 7:00 p.m. and 7:45 a.m. CT
From Monday to Friday between 8:30 a.m. and 1:20 p.m. CTTAS: From Sunday to Friday between 7:00 p.m. and 7:45 a.m.
From Monday to Friday between 8:30 a.m. and 1:15 p.m. CT
Listed Contracts9 monthly contracts of March, May, September
8 monthly contracts of July and December listed annually after the termination of trading in the December contract of the current year
Settlement MethodDeliverable
Termination of TradingTrading terminates on the business day before the 15th day of the contract month

Data Source: CME

Corn Options

Product CodeOZC
Contract Unit1 cotnract for 5,000 bushels
Price QuotationCents per bushel
Minimum Price Fluctuation$6.25 or 1/8 of one cent (0.00125) per bushel
Trading HoursCME Globex: From Sunday to Friday between 7:00 p.m. and 7:45 a.m. CT
From Monday to Friday between 8:30 a.m. and 1:20 p.m. CTOpen Outcry: From Monday to Friday between 8:30 a.m. and 1:15 p.m. CT with post-session until 1:20 p.m. CT immediately following the close
Listed ContractsMonthly contracts listed for 3 consecutive months
Two months of March listed after the termination of trading in the August contract month
Two months of May listed after the termination of trading in the October contract month
2 months of September listed after the termination of trading in the April contract month
6 months of July and December listed after the termination of trading in the December contract month
Settlement MethodDeliverable
Termination of TradingTrading terminates on Friday of the contract week.

Data Source: CME

5. Versatility

In terms of versatility and possible trading strategies that you could apply to both asset classes, options trading is often considered as the better instrument. That is mostly because the contracts’ specifics allow the trader to take advantage of several spread-based strategies.

Here is how this works in practice. Investors can write and buy contracts at the same time, which allows them to tailor spreads according to their preferences and hedge the potential losses. That way, they can benefit from multi-directional price fluctuations and don’t have to try to forecast the market perfectly. Think of it as creating arbitrage opportunities.

Here is an example – imagine that John is interested in trading an AAPL stock just before its major annual event. He isn’t sure how the new devices presented will stack to those of the competitors and how the audience will perceive them. That is why John decides to hedge the risk by an options contract.

Options allow him to create a spread that guarantees he will profit in two scenarios at the same time – either the stock goes up, or it remains stable. If the new devices are stuffed with ground-breaking technology, John will profit. If they aren’t major improvements, he will also profit as the stock will remain quite stable (and will tumble when the sales go live and don’t live up to the projections, which is usually an event in the near future).

That way, John will profit in every case, except if the event turns out to be a major disappointment and the stock tumbles with an immediate effect. Through similar spread-based trading strategy combinations, options contracts allow traders to create multiple potentially-profitable scenarios.

Futures contracts, on the other hand, can make traders money only when they are moving in the right direction. If the instrument goes in the opposite, though, then the potential losses are unlimited.

Quick facts about futures vs options

Here are some quick facts about futures vs options trading that will help you get the complete picture of the industry and the importance of these derivatives for the overall market environment:

  • According to Statista, futures and options trading has been steadily growing for the years since 2013. FIA’s data even points out that for 2019, futures trading volume rose 12% to 19.24 billion contracts, while options trading volume rose 16% to reach 15.23 billion contracts.
  • Even Warren Buffet, undisputedly the greatest investor of all time, sees potential in options trading. You can find more about his ideas in Berkshire Hathaway’s 2008 Investor Letter.
  • North American markets are leading in terms of daily turnover for both futures and options trading worldwide.

Futures vs. Options – what to choose?

In a nutshell, it is worth noting that options and futures are both excellent instruments to trade if you know what you are doing. Both have their pros and cons, and, depending on your trading style, either one or both may suit you.

For example, if you are a beginner, make sure to start with futures. Although they are the riskier instruments, they definitely are way easier to trade. Also, if you have some experience with stocks trading or at least know how things work on paper, it will take you less time to kick-off with futures trading as it is very similar.

Options trading, on the other hand, can be quite complicated for a newcomer, and the learning curve is steeper.

Futures trading is also preferred by day traders and prop shops due to the quality of the asset class, its liquidity, and the associated volatility that allows the professionals, as well as the algorithmic trading firms, to capitalize on trends’ momentum.

Whatever you choose, make sure to do your homework first, learn the basics inside and out, and even try to get beyond them to get a broader understanding. Once your knowledge is sufficient and you have laid the foundation for making informed trading decisions, proceed with opening a demo account to get a sense of how things work on practice. Don’t rush to get in trading with real money unless you feel prepared and disciplined enough.

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