Options Vs. Futures





Understanding Futures Vs. Options

Options and futures contracts involve speculation on the future values of the underlying asset. These contracts are typically used in three ways:

(1) To arrange for the delivery or receipt of the underlying asset.

(2) To benefit from the price movements of the underlying asset.

(3) To hedge against losses on the other positions in the underlying asset or similar asset.

Leverage

Leverage is the use of debt to purchase an investment. This impacts the percentage return on an investment. For example, compare the returns when a $100/share stock rises to $120. If you purchase the shares without leverage (i.e., all cash), your percentage return per share is (($120 - $100) / $100), or 20 percent. However, if you borrowed half of the purchase price ($50/share), your percentage return is (($120 - $100) / $50), or 40 percent.





What Are Futures?

A futures contract that is physically settled obligates the buyer to take delivery (and the seller to make delivery) of a specified quantity and quality of the underlying asset at a specified location on a specified date (the delivery date). Some futures contract are financially settled and do not involve delivery of the underlying asset, but otherwise follow the same daily pricing rules used for physically settled futures. All futures are cash settled daily, meaning the futures exchange apportions gains and losses to the accounts of futures traders after daily trading ends.





Understanding Futures Contracts

Futures contracts trade on futures exchanges according to very strict standards that govern all aspects of the standard contract including the amount and quality of the underlying asset, the amount you must deposit to buy or write the futures contract, the rules for assigning daily profit and loss, and guarantees that the buyer and seller will fulfill their obligations under the contract.





The price of futures contracts has no additional premiums - it simply is the value of the underlying asset. However, you must deposit specified amount of money, called margin, when you buy or write a futures contract, and must continue maintain margin in your trading account while you are in a long or short positions, as specified in the futures contracts.





Futures Contract Mark To Market

At the end of each trading day, the futures exchange moves money between accounts of long and short futures positions in a process called marking to market . If the contract gained value for the day, the amount of the gain moves from the loss accounts (the futures writers, or shorts) to the gain accounts (the futures buyers, or longs). This daily cash settlement continues until the futures contract expires or a futures trader closes out her position.

What Are Options?

An options gives you the right, but not obligation, to buy or sell a set amount of an underlying asset (e.g., such as 100 shares of stock) at a specified price on or before the options expiration date. To make sense of this concept, you must understand how the price of an option changes as the price of the underlying stock changes.





Call Options

Allow the holder to buy the asset at a stated price within a specific time frame.





Put Options

Allow the holder to sell the asset at a stated price within a specific time frame.





Each option contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers .





Basic Option Terms

The set price at which you can buy or sell an asset via an option is called the strike price . The price you pay to buy an option is called the premium. You pay the premium to buy an option, or collect it if you sell (write) , an option. A call can be out of the money, at the money or in the money if the underlying asset price is below, equal to or above the option strike price, respectively. A put has the reverse relationships with the price of the underlying asset, i.e., a put is in-the-money if the asset price is below the strike price.





All options have an expiration date, which usually occurs weekly or on the each month, although this varies with the type of underlying asset.





Option Value Components

An option’s premium stems from two sources. The relationship between the option strike price and the current price of the underlying asset the time left until option expiration.





For example, suppose you purchase one call option for $275 on ABC Corp. stock with a strike price of $85 a share and one month left until expiration. The price of ABC Corp. stock is $87 per share at the time of option purchase. The call’s money value per share is $87 minus $85, or $2. Since the option controls 100 shares, the money value is $200 for the in the money call.





The additional $75 of premium is due to the uncertainty regarding stock price changes until option expiration. This $75 is the time value of the option, which erodes to zero as the expiration date approaches. Time value is a positive for option buyers but a negative for sellers, because buyers want as much time as possible for the underlying asset’s price to move such that the option gains value.





Option Buyers Perspective

As the option buyer (known as the long position). The option expires. If it expires out-of-the-money , it is worthless. If it expires in-the-money, you take or make delivery of the underlying asset. You close out your option position any time before expiration for its current price. You exercise the option to purchase or sell the underlying asset at the strike price, depending on whether the option is a call or put, respectively.





The options money value derives from the fact that you exercise and then selling the resulting shares. If you own an ABC Corp. $85 call when the stock is selling for $90, you will collect at least $5 a share, or $500, by either selling the option exercising the option and selling the underlying shares. Your overall profit will be at least $500 minus $275 ~ your premium ~ or $225. If the option reaches expiration out-of-the-money, the option will expire without any value and your loss is the premium amount $275. Notice that an option buyers can never lose more than the premium amount.





Option Sellers Perspective

As an option seller (known as the short position), you collect the initial premium (in the example, $275) and then hope the option expires out-of-the-money. That’s because an in-the-money option can be exercised against you, which means, in the case of a call, you are obligated to deliver the underlying asset to the option buyer at the strike price.





In the example, suppose option exercised against you when the share price is $90. If you don't already own the shares, you will have to spend $9,000 to acquire the 100 shares but will only receive $8,500 (the strike value, equal to the strike price time the number of shares) for them, giving you a net loss $275 minus $500, or $225. Your potential loss on a call is unlimited, as there is theoretically no limit to asset's price increase, and therefore the strike value.





Key Features

* Beside the differences noted above, there are different things that set two options and futures apart. Here are some significant contracts between these two financial instruments. Regardless the chances to benefit with alternatives, financial specialists ought to be careful about the risk related with them.





* Options and futures are both financial instruments investors can use to create profits or to hedge current positions.





* An options gives the client correct, but not the requirement, buy or sell asset at a particular price at any time during lifetime of the contract.





* A derivatives gives the client requirement to buy a particular asset, and therefore the seller to sell and deliver that asset at a particular future date unless the holder's position is closed before expiration.





Which Is More Profitable Futures Or Options?

Contracts and options have both their benefits and drawbacks and experienced traders often use them depending on the situation. Some traders tend to concentrate on one or the other. Before determining whether to exchange goods, It's best to fully understand the characteristics of each when you decide how to trade commodities. From there, it's just a matter of using the strategies that make the most sense for you.

Advantages Of Futures Trading

* You don't pay a premium to buy a future contract, which saves you money when compared to the premiums you pay on options.





* Futures contracts control more asset than the corresponding options. For example, a stock option control 100 shares of the underlying stock, whereas a stock futures contract might control thousands of shares. For large traders, this is more efficient than buying multiple option contracts (and paying multiple premiums).





* The futures exchanges slice your ultimate gain or loss into daily settlements. For gainers, this means faster access to profits. For losers, it focuses the mind each day on whether to maintain or terminate the position, and whether you will need to add margin to your trading account.





Advantages Of Options Trading

* Long option positions are less risky than futures and short positions, because the potential loss (the premium) is known beforehand. Future contracts are valued by their underlying assets, which means there is no way to know for sure how much you will gain or lose.





* Generally, option premium are smaller than futures margins. For example, you might be able to by an out-of-the-money call for well under $50, whereas you must put up the initial margin on a future contract, often thousands of dollars.





* Option contracts for a given underlying are listed with many different strike prices and expiration dates, meaning that there is large array of premiums available to options traders. In other words, you can control the amount of leverage you are willing to use. Futures contracts have no premiums, and leverage depends only margin requirements.





* Long option positions are not obligated to exercise their options. Physically settled futures are always exercised at expiration.





Are Futures More Profitable Than Options?

There is no right answer as to which instrument is better. It all depends on one’s risk appetite, and view on the market. However, here are a few key points to compare which strategy is better:

(1) Options are optional financial derivatives whereas Futures are compulsory derivatives instruments.

(2) The seller of an option is exposed to unlimited risk but the buyer’s risk is limited to the premium paid. But in the case of Futures, both buyer and seller have equal risk associated with their trades.

(3) The options although they can be rolled but have a different premium for different expiry, but in case of futures, they are rolled over at the same price in the next contract.





For example, if someone has bought the Future contract of XYZ Company at $110 and if upon expiry the price of XYZ is $105, he can simply roll over the position to next expiry at $105 and his entry price is not changed. But in case of option, if an investor bought 110 call options of XYZ Company by paying a premium of $5 and it expires worthless, then he again has to buy next expiry contract by paying a fresh premium (Say $7). So to reach the break-even, the spot price of XYZ Company has to go above $122(110+5+7).





Final Thoughts

Futures and options are similar in many ways, but often tend to used for different purposes. A futures contract is the preferred vehicle for many active traders who want to profit from the up or down moves in the market.





Because of better liquidity, bis ask spreads are usually closer with futures than with options, an important consideration when margins are slim and doubly important if you are working with a limited amount of cash in your trading account.



