What Are the Key Differences between Options and Futures?
Options and futures, two unique investment products, can be confusing for many first-time investors. Though they are similar in some ways, options and futures provide vastly different opportunities. An options contract gives someone the right to buy or sell shares at a specified price at any time but does not obligate the person to do so. A futures contract requires someone to sell or purchase shares on a specific date until the position becomes closed before that specified time. Both products help hedge current investments or grow wealth, but they come with very different risk profiles and have quite diverse markets.
What You Need to Know about Options
An options contract is based on the value of an underlying security, typically a stock. While the contract is in effect, the investor may buy or sell an asset at the specified price. Options often represent offers to buy or sell shares of a stock, but they do not constitute actual ownership until the agreement is executed. Because of that, they are considered a derivative form of investment. Buyers pay a premium for an options contract that is reflective of the strike price, or the rate at which the purchase or sale can occur if the contract is executed.
There are two different kinds of options: call and put options. Call options are the offer to buy a stock at the strike price, while put options are the offer to sell at a given price. The best way to understand how an option works is to look at an example. Imagine that you purchase a call option for a stock trading at $95 currently for the strike price of $100 for three weeks. Three weeks from now, the stock is trading at $110. You can exercise the option to purchase shares at $100 and then immediately resell for a profit of $10 per share. You can also sell the call itself to someone else who can then make a profit.
With a put option, you could set a strike price of $100 for a stock trading at $110. If the stock then falls to $80, you can sell and make a $20 profit per share. With both options, there is the risk that the stock price does not move in the desired direction. If that occurs, then the option is worthless and you lose the premium you paid to purchase it. Depending on the price of the premium, the ability to hedge may be worth it, but it is important to recognize the possibility of losing this money altogether. The answer will likely depend on the amount of the premium.
What You Need to Know about Futures
Unlike an option, a future requires the investor to buy and sell at a future date at a specified price. Investing in futures is a true hedge and is usually for commodities such as corn and oil. Farmers will often lock into a price early in the season before the crop is delivered just in case the market prices fall. Investors also like to lock in this price since there is the chance that prices can rise before the crop is delivered.
For example, imagine a farmer and an investor agree on $60 per bushel on a corn futures contract. The price of corn may fall to $55, at which point the farmer would lose out on $5 per bushel. However, the price could rise to $65, so the buyer would pay an additional $5 per bushel. Locking in this price allows both parties to know exactly what to expect.
While futures began in the commodities market, they can now be purchased on individual stocks or even an index like the S&P 500. When buying a future, the entire amount is not paid at once. A percentage known as the initial margin is paid upfront, while the rest is delivered after the contract is executed. For the most part, futures are for institutional buyers. These buyers will sell barrels of crude oil to refiners or distribute corn to supermarkets. Setting the price upfront protects parties from wild swings in market prices.
Futures are becoming more popular among retail buyers who purchase and sell futures contracts as a sort of bet on how the market will shift. These investors never intend to take possession of products but instead make money by predicting market changes.
Futures prove extremely risky for individual investors since they involve an obligation. Also, for the most part, futures contracts involve a large sum of money. They also come with daily obligations as underlying stock prices move. Gains on futures positions are tracked daily, which means the changes in the value of the positions are transferred to futures accounts at the end of each trading day. For this reason, investors may need to deposit more money into the account, which could create a financial bind.
