An options contract gives an investor the right, but not the obligation, to buy (or sell) shares at a specified price at any time before the contract’s expiration. By contrast, a futures contract requires a buyer to purchase the underlying security or commodity—and a seller to sell it—on a specific future date, unless the holder’s position is closed earlier.
Options and futures are two varieties of financial derivatives investors can use to speculate on market price changes or to hedge risk. Both options and futures allow an investor to buy an investment at a specific price by a specific date. But there are important differences in the rules for options and futures contracts, and in the risks they pose to investors.
- Options and futures are two types of derivatives contracts that derive their value from market movements for the underlying index, security or commodity.
- An option gives the buyer the right, but not the obligation, to buy (or sell) an asset at a specific price at any time during the life of the contract.
- A futures contract obligates the buyer to purchase a specific asset, and the seller to sell and deliver that asset, at a specific future date.
- Futures and options positions may be traded and closed ahead of expiration, but the parties to the futures contracts for commodities are typically obligated to make and accept deliveries on the settlement date.
Options are based on the value of an underlying stock, index future, or commodity. An options contract gives an investor the right to buy or sell the underlying instrument at a specific price while the contract is in effect. Investors may choose not to exercise their options.
Options are financial derivatives. Option holders do not own the underlying shares or enjoy shareholder rights unless they exercise an option to buy stock.
Options contracts for stocks typically provide the right to buy or sell 100 shares of the stock at the specified strike price before the contract expiration date, and the price of the option is known as its premium.
In the U.S., the equity options market is open from 9:30am – 4:00pm EST; the same as normal stock trading hours. Options exchanges are also closed on holidays when stock exchanges are closed.
Types of Options: Call and Put Options
There are only two kinds of options: Call options and put options. A call option confers the right to buy a stock at the strike price before the agreement expires. A put option gives the holder the right to sell a stock at a specific price.
Let’s look at an example of each—first of a call option. An investor buys a call option to buy stock XYZ at a $50 strike price sometime within the next three months. The stock is currently trading at $49. If the stock jumps to $60, the call buyer can exercise the right to buy the stock at $50. That buyer can then immediately sell the stock for $60 for a $10 profit per share.
Alternatively, the option buyer can simply sell the call and pocket the profit, since the call option is worth $10 per share. If the option is trading below $50 at the time the contract expires, the option is worthless. The call buyer loses the upfront payment for the option, called the premium.
Meanwhile, if an investor owns a put option to sell XYZ at $100, and XYZ’s price falls to $80 before the option expires, the investor will gain $20 per share, minus the cost of the premium. If the price of XYZ is above $100 at expiration, the option is worthless and the investor loses the premium paid upfront. Either the put buyer or the writer can close out their option position to lock in a profit or loss at any time before its expiration. This is done by buying the option, in the case of the writer, or selling the option, in the case of the buyer. The put buyer may also choose to exercise the right to sell at the strike price.
What’s The Difference Between Options And Futures?
A futures contract is the obligation to sell or buy an asset at a later date at an agreed-upon price. Futures contracts are a true hedge investment and are most understandable when considered in terms of commodities like corn or oil. For instance, a farmer may want to lock in an acceptable crop price in case market prices fall before the crop can be delivered. The buyer also wants to lock in a price to protect against a subsequent rise in prices.
Let’s demonstrate with an example. Assume two traders agree to a $7 per bushel price on a corn futures contract. If the price of corn moves up to $9, the buyer of the contract makes $2 per bushel. The seller, on the other hand, loses out on a better deal.
The market for futures has expanded greatly beyond oil and corn. Futures can be purchased on an index like the S&P 500, and on individual stocks in some jurisdictions. (Single-stock futures have not been available in the U.S. since 2020.) Buyers of a futures contract are not required to pay the full value of the contract up front. Instead, they cover a percentage of the price as an initial margin.
For example, an oil futures contract is for 1,000 barrels of oil. An agreement to buy an oil futures contract at $100 requires the buyer to risk $100,000. The buyer may be required to pay several thousand dollars up front, and may be required to increase that commitment later if oil prices subsequently drop.
Futures markets primarily serve institutional investors. These may include refiners seeking to hedge crude costs or cattle producers seeking to lock in feed prices.
Who Trades Futures?
Futures markets serve commodity producers, commodity consumers, and speculators. Futures contracts can protect buyers as well as sellers from wide price swings in the underlying commodity. They also cater to institutional as well as retail traders seeking to profit from expected changes in market prices for the underlying security or commodity. Financial speculators typically don’t intend to acquire the underlying commodity when the contract is settled, and are likely to sell their position beforehand.
Futures trading hours may differ from stock and options markets. Normal trading hours are often 8:30a.m.–3:00p.m., with electronic trading on the CME’s Globex platform overnight from 5:00p.m.–8:30a.m. CT. Some futures products trade 24-hours a day on Globex.
Aside from the differences noted above, there are other things that set options and futures apart. Here are some other major differences between these two financial instruments.
Because they tend to be fairly complex, options contracts tend to be risky. Call and put options can be equally risky. When an investor buys a stock option, its risk is defined by its cost, or premium. In the worst case scenario, the option premium spent will be a total loss if the options expire worthless.
However, selling a put option exposes the seller to a loss potentially much larger than the premium gained from a possible decline in the value of the shares underlying the stock option. If a put option gives the buyer the right to sell the stock at $50 per share but the stock falls to $10, the seller remains on the hook to purchase the stock at $50 per share.
The risk to the buyer of an option is limited to the premium paid up front. An option’s price fluctuates based on a number of factors, including how far the strike price is from the underlying security’s current price, as well as time remaining before expiration. This premium is paid to the seller of the put option, also called the option writer.
The Option Writer
The option writer is on the other side of the trade. Option sellers take on more risk relative to option buyers. Since there is no upper bound to a share price, there is no upper limit to how much the seller of a call option can lose on the rise in the share price. Option sellers may own the underlying stock to limit their risk.
The option buyer as well as the option seller may trade out of the position in the options market.
Options may be risky, but futures can be riskier still for the individual investor. Futures contracts obligate both the buyer and the seller. Futures positions are marked to market daily, and, as the underlying instrument’s price moves, the buyer or seller may have to provide additional margin.
Futures contracts require a significant capital commitment. The obligation to sell or buy at a given price makes futures riskier by their nature.
Examples of Options and Futures
To complicate matters, options are bought and sold on futures. But that allows for an illustration of the differences between options and futures. In this example, one options contract for gold on the Chicago Mercantile Exchange (CME) has as its underlying asset one COMEX gold futures contract.
An options investor could have purchased a call option for a premium of $2.60 per contract with a strike price of $1,600 expiring in February 2019. The holder of this call would have had a bullish view on gold and held the right to assume the underlying gold futures position until the option expiration after the market close on Feb. 22, 2019. If the price of gold rose above the strike price of $1,600, the investor would have exercised the right to buy the futures contract. Otherwise, the investor would have allowed the options contract to expire. Their maximum loss was the $2.60 premium paid for the contract.
The investor might have purchased a futures contract on gold instead. One futures contract has as its underlying asset 100 troy ounces of gold. This means the buyer is obligated to accept 100 troy ounces of gold from the seller on the delivery date specified in the futures contract. Assuming the trader has no interest in actually owning the gold, the contract will be sold before the delivery date or rolled over to a new futures contract.
As the price of gold rises or falls, the incremental gain or loss is credited to, or debited against, the investor’s account at the end of each trading day. If the price of gold in the market falls below the contract price the buyer agreed to, the futures buyer is still obligated to pay the seller the higher contract price on the delivery date.