Futures and options are financial contracts that exist between a buyer and seller of an underlying security.
These financial contracts can be used by investors to generate a profit or hedge against a loss in an investing portfolio. By reading this article, investors will understand the key differences that separate futures and options from each other.
An options contract grants the buyer of the contract the right, but not the obligation, to buy or sell an underlying security at a specific price by an expiration date.
There are two types of options: calls and puts. An investor can buy a call or put, or an investor can sell a call or put.
A call option grants the buyer the right to buy an underlying stock at a specific price before or on the expiration date.
For example, assume stock ABC is trading at $20. An investor expects the stock’s price to increase so he buys a call option with a strike price of $22 that expires in a month. He pays a premium to the seller for the option. At expiration, if the stock rises above $22, say to $25, then the buyer can exercise his right on the option and buy the stock at $22. He can then sell the stock at $25 to generate a profit of $3 per share. At expiration, if the stock is below $22, then it will expire worthless and the buyer will lose the premium he paid for the option.
A put option grants the buyer the right to sell an underlying stock at a specific price before or on the expiration date.
For example, assume stock ABC is trading at $20. An investor expects the stock’s price to decrease so he buys a put option with a strike price of $18 that expires in a month. He pays a premium to the seller for the option. At expiration, if the stock falls below $18, say to $15, then the buyer can exercise his right on the option and sell the stock at $18. To do this, he can buy the stock at the market price of $15 then immediately sell at the strike price to generate a profit of $3 per share. At expiration, if the stock is above $18, then it will expire worthless and the buyer will lose the premium he paid for the option.
A futures contract grants the buyer the obligation to purchase an underlying security, and the seller to sell that underlying security, at a specific price on a specific future date.
For example, assume two investors agree to $50 on an oil futures contract. The buyer is agreeing to buy the oil at $50 while the seller is agreeing to sell the oil at $50. Say that the contract expires in exactly one week. At the end of that week, if oil is trading at $55, then the buyer of the contract is going to make a profit of $5. The seller is going to be losing $5 since he is selling at $50 when he could be selling at $55.
The key difference between options and futures contracts is that options are a right and futures are an obligation. In futures, both parties involved face a lot of risk as prices could move against them. In options, the risk is limited for buyers and theoretically unlimited for sellers.
Although options and futures have some similarities, the difference between the two is important. Futures are simple to understand but carry a significant amount of risk. Options can be very complex to understand but the risk involved could be more or less than that of futures.
Investors should approach options and futures strategically and cautiously to avoid potential loss. However, options and futures offer investors the opportunity to earn substantial returns and ways to diversify an investment portfolio. For those reasons, futures and options are great tools to use in an investor’s playbook.
