What are options?

Understanding futures and options

Futures are an obligation to buy or sell the underlying asset in the future to another party, whereas buying an option provides the right to buy or sell the underlying asset at a future date. With a futures contract​​​, a trader pays the current price of the contract but doesn’t have to take delivery or receive the underlying asset until later. If the price is higher in six months, they would profit from locking in a lower price. If the price is lower in six months, they would incur losses because they paid a higher price than needed.

Buying an option is used if a trader may want to buy or sell the underlying asset in the future. Assume a trader buys an option with a chosen strike price and expiry. If the price of the underlying asset is above the strike price for a call option or below the strike price for a put option, they have the right to buy (use a call option) or short (sell a put option) the asset at the strike price. But upon taking the trade, they are not obligated to buy at the strike price.

Buying and selling

Futures traders tend to buy a contract if they think the underlying asset will rise. Otherwise, they could short sell the contract if they think the underlying asset will fall. Options are divided into puts and calls. A trader can buy a put if they expect the price of the underlying to drop before expiry. If they expect the price of the underlying to rise before expiry, they can buy a call.

Options are divided into puts and calls; a trader can buy a put if they expect the price of the underlying to drop before expiry — if they expect the price of the underlying to rise before expiry, they can buy a call.

Expiry date length

Futures expiry dates can be many years in the future, usually expiring on the same day each month or quarter, whereas option expiry dates are typically a year or less; usually weekly, monthly or quarterly, depending on the underlying market. Options that expire more than a year into the future are called long-term equity anticipation securities.

Futures speculators aren’t usually interested in delivering or receiving the underlying asset, as they are more interested in participating in the price changes. If a trader believes an asset’s price will be higher, they could buy a futures contract on the spot. If they are right, they could sell their contract before expiry and profit from the price difference. Speculators tend to close their trade before the contract expires, otherwise they are obligated to deliver the underlying asset or settle the value of the contract in cash.

As for options, if a trader believes a stock may move up to $65, say, over the next six months and it is at $60 right now, they may choose to buy an option contract for $1 (called the premium), that gives them the right to buy the stock at $60 (the strike price) for the next six months.

Potential losses

In order to prevent future losses, some traders use controls such as a stop-loss order​​​, as the price can rise or fall indefinitely (even below zero). Since a futures contract is an obligation, that obligation persists regardless of price until the obligation/trade is closed.

When buying an option, the maximum loss is the cost of the premium paid no matter how much the underlying asset price moves.

Leverage

Futures are often traded using leverage​​​, which means controlling a lot of underlying assets with a small amount of cash. With options, you pay a premium to potentially see a profit or loss on price movements of the underlying asset.

For futures, a trader is required to have only a small portion of the value of the underlying asset in their account. For example, a forward contract is very similar to a futures contract, and the trader is required to have only 5% of the bet size in their account. Trading a contract worth $1,000 of the underlying product requires only $50 in the account to initiate the trade.

When might you pick one over the other?

Both markets have their uses. A futures contract is useful if you want to take a position right now to profit directly from price movements in the underlying asset over a certain timeframe. A futures contract is also useful if you want a lot of leverage, which can magnify potential profits (and losses).

An option contract may be more suitable if you want to cap potential losses to the premium paid while still gaining exposure to the underlying asset. This can be useful, for example, when a stock has earnings. You could buy a call if you expect a big upward price move. If it happens, you likely profit, but if the stock plummets, you have capped your risk at the premium paid.

A futures contract is useful if you want to profit directly from price movements in the underlying asset over a certain timeframe; an option contract is more suitable if you want to cap potential losses to the premium paid.

What are the costs related to trading futures?

When trading futures, you will pay a commission to enter and exit the trade. If the position is not closed before expiry, the contract must be settled with cash or delivering/receiving the underlying asset. As an alternative, when trading forward contracts with us, you are speculating on the price movement of the contract, so are never on the hook for delivering/receiving anything. At the end of the contract, you are able to roll it over to the next contract to maintain your exposure to the trade.

What are the costs related to trading options?

You typically pay a commission to enter and exit an options trade, as well as a premium typically, which is the cost of the trade/wager. If the underlying asset is above the strike price at expiry for a call or below the strike price for a put, then the option is considered ‘in the money’. This means the buyer of the option assumes the position underlying the option. This can result in additional cash outlays.
 

Futures vs options: the key similarities

• Both contracts have expiry dates.

• Both markets provide a way to participate in the underlying asset without owning it.

• Both provide exposure to a market with a smaller amount of cash than having to buy the position outright.

• Both have a current price, which changes through to expiry based on the performance of the underlying asset.

• Both speculators can profit (or lose) from the price difference they buy and sell at.

• Both are traded through exchanges that oversee all transactions.

• Both can be used for speculative purposes or to hedge other trading positions.

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