Options and futures are both commonly used trading tools in the world of investment and finance. Trading either of them is a little more complicated than simply buying stocks (which is a form of investment that many people have at least a basic understanding of). Used correctly, they both offer plenty of opportunities for making money. Options and futures are both widely used to benefit from leverage and they are also both useful tools for hedging purposes.
However options and futures are actually very different from each other. Despite this fact, they are often confused with each other and investors that don’t fully understand how they differ from each other can make the mistake of thinking options trading is essentially the same thing as futures trading.
This can be a very costly mistake, and no one should ever get involved with any kind of financial trading or investment without knowing exactly what they are doing. On this page we highlight the similarities between options and futures, look at the main difference between the two, and explain why we believe options trading offers many advantages.
Similarities Between Futures & Options
It should be made clear that there are certain similarities between options and futures, and it is understandable how even relatively experienced investors can get the two confused. They are both financial contracts that exist between two parties – the buyer and seller of an underlying asset. They can both be traded on public exchanges, although some of the more complex contracts are only sold over the counter.
They are also both leveraged derivatives – although if you know what this means the chances are that you can already recognize the difference between the two. Basically, a derivative is a financial instrument that derives its value primarily from one or more underlying asset. Leverage is a term for any technique that you use to effectively multiply the power of your capital.
For example, if you buy stocks in a company then you physically own a share in that company and the asset you own can go up or down in value. When buying a derivative, you are buying a contract which is valued according to the underlying asset on which it's based and possibly other factors such as the length of the contract.
Leverage is when you effectively multiply the power of the cash you are investing to generate larger returns; this is possible with both options and futures and is the main reason why they are known as leverage derivatives.
Major Difference Between Futures & Options
The fundamental difference between options and futures is in the obligations of the parties involved. The holder of an options contract has the right to buy the underlying asset at a fixed price, but not the obligation. The writer, or seller, of the contract is obligated to sell the holder the underlying security (or buy it), if the holder does choose to exercise their option.
This obviously puts the holder of a contract at an advantage, because if the underlying security moves against them, they can simply let the contract expire and not incur any losses over and above the original cost. If the underlying security moves in the right direction for the holder (and therefore against the writer), then the writer must honor their obligation.
In a futures contract, both parties are obliged to fulfill the terms of the contract at the point of expiration. This is a very significant difference. Buying a futures contract where you will be obliged to buy a particular security at a fixed price carries much more risk than buying an options contract where you have the right to buy a particular security at a fixed price, but are not obliged to go through with it if that security fails to move up in value as you expect. Both parties involved in a futures contract are effectively exposed to unlimited liability.
The costs involved are also different. When an options contract is first written, the writer of it sells it to the buyer and receives the money that the buyer pays. Depending on the terms of the contract, the underlying security involved, and the circ*mstances of the writer, the writer may have to have a certain amount of margin on hand. They may also be required to top up that margin if the underlying security moves against them. However, the buyer owns those contracts outright and no further funds will be required from them.
With futures, though, as both parties are exposed to losses depending on which way the price of the underlying security moves, they are both required to have a certain amount of margin on hand. Price differences on futures are settled daily, and either party could be subject to a margin call if the value of the underlying security has moved against them. This contributes largely to why futures trading is generally considered riskier than options trading. Below we look at a couple of the advantages trading options has to offer.
Advantages of Options Over Futures
As mentioned above, when trading futures you are potentially exposed to big losses whichever side of the contract you are on. If you have the obligation to buy an underlying security at a fixed price and the security moves significantly above that fixed price, then you could lose substantial sums. Conversely, if you have the obligation to sell an underlying security at a fixed price and the security moves significantly below that fixed price then you could experience sizable losses.
If you are writing options contracts and taking on an obligation to either buy or sell an underlying security at a fixed price, then you are exposed to similar risks. However, you can trade options purely by buying contracts and not writing them. This means that you can limit your potential losses on each and every trade you make to the amount of money you invest in buying specific contracts.
Whenever you buy options contracts, the worst case scenario is that they expire worthless and you lose your initial investment. Even if you do want to write contracts in addition to buying them, you can easily create spreads to ensure that your losses are always limited. The potential for limited liabilities in options trading is a major advantage, particularly for those that are against high risk investments.
Another big advantage options trading offers is versatility. There are a number of strategies that you can use to create spreads that enable you to profit from multi-directional price movements. For example, you could create a spread that would result in profit if the underlying security went down in value a little bit, or if it stayed stable, or if it went up in value by any amount. This would only result in limited losses if the underlying security went down a significant amount.
With futures contracts, you can typically only make money from the underlying security moving in the right direction for you. There could be unlimited losses if your investment moves in the wrong direction or if a neutral result occurs.
