Investors use options and futures contracts to earn profits and hedge their investments against loss. Many investors find trading options contracts less risky and more flexible than trading futures contracts. Options and futures are considered derivatives, which are financial securities that derive their value from underlying assets, such as stocks. Understanding which financial instruments you want in your investment portfolio begins by knowing what options and futures are.
An options contract gives you the right to buy or sell the underlying asset, but you're not obligated to do so. You can invest in two types of option contracts -- call and put options. You must pay a premium for the trading rights associated with options. When you buy a call option, you secure the right to purchase the underlying stock at a specific price and a predetermined time. When you buy a put option, you secure the right to sell an asset at a specific price and date in the future.
Futures contracts legally bind you to buy or sell an asset at a specific date in the future and for a predetermined price. You must put up a margin payment with a brokerage firm to trade futures, which is the initial payment required to trade using margin. Trading using margin means you borrow a portion of the funds needed for investing from the brokerage firm. If you agree to sell an asset using a futures contract, you hope the price of the contract goes down. If the price increases, you’ve locked yourself into a loss. If you agree to buy an asset using a futures contract, you hope the price increases. If the price of the asset declines, you can possibly pay substantially more than market price of the asset.
Trading option contracts is typically less risky than trading futures contracts, because buying call or put options does not obligate you to buy or sell assets. Your risk is limited. If the investment is unprofitable at the end of the contract, you simply let the option expire and only lose the amount of the premium. Regardless of the amount of the underlying asset at the specified time on the futures contract, by contrast, you must buy or sell the assets according to the contract price.
Unlike future contracts, you know the price of trading an option before you invest any money. You can profit in more than one way by trading option contracts. If the contract is deemed profitable when the contract expires, you can buy or sell the underlying assets for a profit or you can sell the option contract to another investor for a profit. According to the Chicago Board Options Exchange, an advantage of option trading is that the contracts are sold in liquid markets. The National Futures Association states there is no guarantee that a liquid market will exist for future contracts.
- College of William & Mary: Walking Through Some Examples of Futures and Options Contracts -– Speculation and Hedging
- Chicago Board Options Exchange: Understanding Stock Options
- Orion Futures Group, Inc.: Understanding Opportunities and Risk in Futures Trading
- U.S. Securities and Exchange Commission: Margin -- Borrowing Money to Pay for Stocks
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