While the difference between futures and options contracts is one of life’s more subtle separations, it is nevertheless one of the most commonly asked questions by novice investors.
There is no doubt that trading options and futures involves some similarities, but the differences are quite marked and need to be fully understood before successful financial trading can be assured.
Just to recap, here is the Wikipedia short definition of both types of contracts:
- an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike). The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction.
- a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed today (the futures price or strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are negotiated at a futures exchange, which acts as an intermediary between the two parties.
Now, let us have a look at the main differences between options and futures:
- While both futures and options are derivatives (which means they each derive their value from an underlying security), their most significant difference is that options give the right (but not the obligation) to buy or sell that underlying security, whereas a futures contract is a legally binding obligation to buy or sell that same commodity. This means that when trading options your loss is limited to the price paid for that option but in a futures trade, the loss could amount to the entire investment in order to satisfy the contractual obligation.
- A further difference rests in the amount of upfront cost in a futures contract versus an options contract. As mentioned above, the initial price of the option is the maximum loss than can be incurred, so the option price represents a fee for being able to decline purchase of the underlying asset should market conditions be unfavorable. On the other hand, a futures contract can be entered into without any costs or fees, although in both instances commissions may apply based on individual broker arrangements and the like.
- As explained in our detailed article on options trading, profits can be realized prior to the option expiry date, and whether the market is up or down. However, a futures contract is assessed at the conclusion of each trading day with the resulting adjustment to the investor’s account.
- The relative contract size between futures and options is usually far greater for futures, which means both the gains (and losses) can be significantly more for a futures contract. Of course this makes for riskier trading and should be the domain of more experienced investors.
In summary then, both options and futures contracts are exciting and potentially very profitable methods of financial trading. The risks are greater with futures trading but in return the upside for wealth generation is immense.
If you would like to learn more about trading futures contracts, then we highly recommend the software and trading resources offered by Gecko Software, the leading provider of online trading tools since 1998.
To your trading success.