Futures vs. Options Trading: The Difference You Should Know

The gradual change in the values of things, whether a stock in a company, euros versus dollars, agricultural produce, or a stock index, means that investors can buy and sell assets based on their expected future worth instead of their current price.

These kinds of transactions are commonly called futures and options.

Table of Contents Table of Contents

1. Key Takeaways
2. What Are Futures and How Do They Work?
3. What Are Options and How Do They Work?
4. Key Differences Between Futures vs. Options
5. The Bottom Line: Which Is Better for You?
6. FAQs
7. References

Show Full Guide

Table of Contents

1. Key Takeaways
2. What Are Futures and How Do They Work?
3. What Are Options and How Do They Work?
Show Full Guide
4. Key Differences Between Futures vs. Options
5. The Bottom Line: Which Is Better for You?
6. FAQs
7. References

What Are Futures and How Do They Work?

These contracts are standardized and traded on exchanges, allowing investors to hedge risk or speculate on future price movements.

There are many types of futures, and these instruments aren’t limited to stocks. Foreign currencies and commodities (raw materials traded on a large scale, like oil and gold) are often the subjects of futures contracts.

Example of Futures Trading

For example, a retired soybean farmer uses his industry know-how to predict that this year’s North American harvest will fail. He reasons that the price will rise.

He decides to buy soybeans for $15 per bushel, but only in September, certain that he will be able to sell them for more at that time. Future contracts must specify both a settlement date and the price at which the sale will be transacted.

The farmer transfers enough money to cover the “margin” – a deposit of 5% or so to show good faith – and the contract is signed.

If these beans are worth less than $15 at the time, he’s on the hook for the difference. Conversely, if the spot price is higher than the contract price, he will make a profit when they’re sold.

The farmer could have alternatively gone short the soybean futures, in which case his ‘payoff’ is inverted. He would start to make money when the price falls below $15 and lose money when it is above.

Who Benefits From Futures Contracts?

Futures aren’t just a mathematical game made up by speculative investors. Suppose:

• Your company needs those soybeans to manufacture dog food.
• You’re a farmer who’d like a guaranteed price for your crop, perhaps as collateral for a loan.
• You plan to import soybeans from China and don’t know what the renminbi exchange rate will be like at harvest time.

In each of these situations, you’d obviously prefer to get the best possible price, but, in practice, fixing a reasonable price (that ensures you turn a satisfactory profit) ahead of time makes your planning far simpler and reduces other risks.

What Are Stock Futures?

A stock futures contract works just like one concerning soybeans: it’s an agreement to accept (or deliver) a certain number of shares on a specific date at a given price.

The nature of each market may make either options vs. futures more attractive to buyers and sellers, though. So, futures are indeed generally associated with things like raw materials while options make most people think of the stock market.

Really, though, these words are just a kind of shorthand for two legal formats for contracts covering transactions to take place at a later date.

What Are Options and How Do They Work?

The investor who owns the option may also decide to simply let it lapse. If Jim had an option on soybeans instead of a future and the price fell to below $15 per bushel, he could simply walk away without any legal consequences. This kind of situation is referred to as being OTM, or “out of the money.”

Example of Option Trading

An aspiring investor wants to start investing in the stock market cautiously. She has identified a promising but volatile stock and wants to safeguard her trading since she isn’t constantly monitoring the market. To do this, she can use options.

If she believes the stock price will rise, she can buy a “call” option. For example, she can buy a call option with a strike price of $10.50. If the stock price exceeds this strike price, she can buy the stock at $10.50 and potentially sell it at a higher market price, making a profit. She will need to pay a premium for this option, which gives her the right to buy the stock at the strike price.

Alternatively, if she owns the underlying shares but is worried the stock price might temporarily drop, she can use a “put” option as a hedge. For instance, if she buys the stock at $9 per share, she can buy a put option with a strike price of $8. If the stock price falls below $8, the profit from the put option can offset the losses on her shares. She will need to pay a premium for this put option, which acts as insurance against the stock price dropping.

The payoff for an options contract can be thought of in terms of the value of the option. When the option has value, you can sell it for a profit; when it doesn’t, it is worthless.

In options trading, “in the money” (ITM) and “out of the money” (OTM) are terms used to describe the intrinsic value of options contracts:

“In the money” (ITM) options have a strike price favorable to current market conditions, making them exercisable for a profit, while “out of the money” (OTM) options have a strike price that is not favorable, making them currently unprofitable to exercise.

Key Differences Between Futures vs. Options

Both options and futures can be used to speculate, i.e. to take a position that the market will move in a certain direction. Both are also tools to limit losses due to unexpected price swings. Both can also be bought or sold in the open market after the contract has been made.

Nonetheless, there are significant differences between options and futures:

Futures vs. Options: Side-By-Side Comparison

The Bottom Line: Which Is Better for You?

When considering trading futures vs. options, it’s essential to understand the distinct purposes and complexities of each. Both can be used to reduce risk or capitalize on market volatility and can be integrated into an investment strategy, but they serve different roles.

Ultimately, the choice between options and futures – or whether to use them at all – depends on your specific investment goals, risk tolerance, and ability to perform detailed market analysis. If you’re unsure or lack the necessary resources, traditional investment approaches may be more suitable.

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