Options and futures are two financial products that investors use to make money or to hedge current investments. These two are agreements to buy an investment at a particular price at a particular date.
Basically, an option offers the investor the right but not the obligation to buy or sell shares at a specific price at any time the contract is in effect.
On the flipside, a futures contract requires a buyer to buy shares and a seller to sell on a particular future date. That is, unless the holder’s position is closed before the expiration date.
Options: Two Types
There are two types of options: calls and puts options.
A call option is basically a contract to buy a stock at a price, which is called the strike price, before the expiration date of the agreement. Meanwhile, a put option is a deal to sell a stock a specific price.
In both cases, the options are a derivative of the investment, which means the buying or selling don’t go with the actual ownership of the underlying investment until the agreement has been finalized.
For the call option, the risk to the buyer is limited to the amount paid to buy the contracts, and this price is called the premium.
This premium price rises or falls through the life of the contract. This premium is given to the option writer, who is the person on the other side of the trade. The option write is generally perceived to have unlimited risk.
A futures contract provides the obligation to sell or buy an asset at a later date at an agreed price. To understand futures, it is best to view them under the lenses of a commodity trader.
Futures contracts are considered to be true hedging investments. For instance, a farmer may want to lock in an acceptable price upfront in case the market prices fall before the crop has been delivered.
Meanwhile, the buyer wants to lock in a price upfront as well in case the prices soar by the time the crop has been delivered.
Who are the Futures Traders?
In the futures market, you must understand the vast differences between institutional and retail traders.
Futures contracts came about because of institutional investors who intend to actually have possession of barrels of crude oil to sell to refiners.
Setting a price in advance protects the businesses on both sides of the trade from big, unpredictable price swings.
Retail buyers, on the other hand, buy and sell futures contracts as speculation on the price direction of the underlying security. These traders aim to profit from the changes in the price of the futures, whether up or down.
Futures are Riskier
The dynamics of options contracts make it possible to have varying degrees of risks for the buyers or sellers.
Meanwhile, futures involve the highest liability for both the buyer and the seller. As the underlying asset’s price moves, the parties may have to deposit more money into their trading accounts to fulfill their daily obligation.