Futures and options are advanced investing instruments for those looking to take their investment strategies to the next level. Despite the fact that both are derivatives (meaning they derive their value from an underlying asset), both have some critical differences, and each has its own risks and benefits. In this guide, we’ll cover the differences between futures and options, the advantages of each, and how to choose between them. Here’s our futures vs. options comparison.
What Is Futures Trading?
Futures are derivative contracts between two parties where they agree to trade a particular asset at an agreed-upon price at a future date. In a futures contract, one party agrees to sell the underlying asset, while the other agrees to buy it. No matter what happens with the market price of the underlying asset in the future, the transaction is made at the price stated in the contract.
A person chooses a futures contract for one of two reasons:
- First, a futures contract helps a seller guarantee their ability to sell an asset at a particular price. They’re hedging their risk in case the price goes down.
- Second, a buyer buys a futures contract as a form of speculation. They’re hoping the market price of the asset goes up so they can buy it for the price in the contract and then sell it for a profit.
Futures contracts can be made for assets such as stocks, bonds, commodities, currencies and more. Futures are traded on futures exchanges like the CME Group, Nasdaq Futures Exchange, and Intercontinental Exchange.
What Is Options Trading?
An option is another type of derivative contract between two parties where the buyer has the right — but not the obligation — to buy or sell the underlying asset at a certain price (known as the “strike price“) before the contract’s expiration date.
The party that buys the options contract (and thereby owns the contract) has the right to make the transaction but is not required to do so. But if the contract’s owner decides to buy or sell the asset, the other party is obligated to honor the agreement.
You can buy options contracts through many of the same brokerage firms that trade stocks and exchange-traded funds (ETFs). In fact, many brokerages offer commission-free trading on options.
There are two types of options we should discuss.
A call option gives the owner the right (but not the obligation) to buy a specific underlying asset at the strike price before the expiration date. For example, someone may purchase a call option for an asset they expect to increase in price. If the asset’s price does rise, they can purchase the asset at the lower strike price and then turn around and sell it for a profit. If the owner of the option exercises their right, the other party is obligated to sell the asset to the owner at the agreed-upon price.
A put option gives the owner the right (but not the obligation) to sell a specific underlying security at the strike price before the expiration date. For example, someone may purchase a put option for an asset they currently own to hedge their risk against the asset price going down. If the asset’s market price drops, the owner can sell the asset for more than they could get on the open market. If the owner exercises their right, the other party is obligated to buy the asset from the owner at the agreed-upon price.
Key Differences Between Futures and Options
Futures and options are both derivatives, meaning their value comes from an underlying asset. They each have two parties who are essentially speculating as to which direction the asset’s price will move. But despite their similarities, there are also some important differences.
One of the most important differences between futures and options is the liability.
In the case of an options contract, one party carries most of the risk. The contract’s owner can choose whether or not to exercise the option. If the owner doesn’t exercise it, their loss is limited to the price they paid for the contract. But if the owner exercises it, the seller of that contract is obligated to honor it.
But in the case of a futures contract, both parties carry the liability because both are obligated to transact.
The Expiration Date
Another key difference is the expiration date. In the case of futures contracts, the transaction happens on a particular day as laid out in the contract. Neither party has the ability to initiate the transaction on an earlier date.
But in the case of an options contract, the expiration date is simply the latest the transaction can happen. The owner can decide to exercise the option at any time before that date.
Advantages of Futures Over Options
- Exposure to other asset classes: It’s easy to invest in primary asset classes like stocks and bonds. But most investors don’t have much exposure to alternative investments like commodities and currencies. Futures contracts are a way for you to gain exposure to those assets and diversify your portfolio.
- Liquidity: The futures market is highly liquid, meaning you can enter and exit positions fairly easily. You don’t have to worry about being stuck with a contract you don’t want.
- No time decay: The value of an options contract declines as it gets closer to the expiration date. That’s not the case with futures contracts. This means you don’t have to worry that the resale value will decline.
Advantages of Options Over Futures
- More flexibility: When you enter into a futures contract, you’re obligated to go through with the transaction. But if you buy an options contract, the choice is yours. You can exercise the option if it’s profitable for you or simply allow it to expire if it isn’t.
- Limited loss: When you purchase options, your loss is limited to the amount you paid for the contract. No matter how much of a price swing the asset has, your loss doesn’t increase.
- More accessible: Anyone with a brokerage account can purchase options contracts. They’re widely available on most trading platforms, while futures contracts aren’t.
Futures vs Options Risk Comparison
Futures, options and other derivatives are advanced investing strategies that are considered to be high risk. But the risks are slightly different.
In the case of futures contracts, both parties in the contract have the risk of substantial loss. One party faces significant loss if the asset’s price drops, while the other faces significant loss if the price increases.
In the case of options, the two parties have very different levels of risk. The owner of the options contract has relatively minimal risk. Regardless of how much the price swings, the most you can lose is the amount you paid for the contract. The other party has a significantly higher risk — the more drastic the price swing in the wrong direction, the greater their potential loss. And because the owner holds all the power, the other party isn’t likely to experience a substantial gain.
Futures and options also have some risks in common. Both are considered high-risk investments because they are unpredictable. And because they are both speculative in nature, they aren’t suited for beginner investors. Unless you have a solid understanding of derivatives, it’s best to stick with simpler investments.
How to Choose Between Futures and Options
Are you ready to start trading derivatives? You may wonder how to decide whether futures or options are best for your portfolio.
- Consider the type of underlying asset you’d like to speculate on. Options often have stocks as their underlying asset. Futures often have alternative investments, such as commodities, as their underlying asset. It’s critical that you speculate only on assets that you understand, so if you’re experienced with stock investing but aren’t familiar with commodities, then options could be a better choice.
- Consider the amount of risk you’re willing to take on. Options have minimal risk of loss for the owner. Futures on the other hand have a high risk for both parties. When you’re just getting started or have a low to moderate risk tolerance, options could be the better choice.
Real-life Example of a Futures Contract
Suppose that two investors, John and Jill, enter into a futures contract for oil where John will pay Jill $75 per barrel of oil on a certain date. John thinks the price of oil is going to increase, and if it goes above $75 per barrel, the futures contract will be profitable for John. Jill thinks the price of oil is going to decrease, and if it does, she’ll make a profit by selling the barrels for $75 apiece.
Both John and Jill risk losing money. John loses if the price of oil goes down, and he has to pay more than the market rate. Jill on the other hand loses if the price increases and she has to sell the barrels to John for less than she could get on the open market.
Real-life Example of an Options Contract
Steve decides to invest in his favorite company, Tesla. He believes in the company and feels confident the stock price will increase. So he buys the stock. But he also wants to hedge his risk. So Steve buys a put option that gives him the right to sell his Tesla stock for a certain price. If the price of Tesla stock declines, Steve exercises the option and sells his stock for more than the market price, minimizing his losses. If Tesla’s stock price rises, Steve simply lets the option expire, and he loses only the premium that he paid for the contract.
Bottom Line: Which One Is Better for You?
Futures and options are both derivatives that allow investors to speculate on the price of the underlying asset. Both are advanced investing strategies and are well suited for different situations and investments. One isn’t necessarily better than the other.
When it comes to deciding which is right for you, consider the type of underlying asset and the amount of risk you’re comfortable with. No matter which you choose, it’s important that you fully understand the underlying asset and the contract itself.