Options and futures are two types of contracts known as derivatives, meaning they derive their values from their underlying assets. The price movements of these underlying assets – which include stocks, stock indexes, currencies, bonds and commodities – determine the ultimate profit or loss on these contracts. While sharing some similarities, the differences between futures and options significantly impact their risk/reward profiles. In general, futures are more efficient and control larger amounts of underlying assets, whereas options are more flexible and affordable.
Understanding Futures vs. Options
Option and future contracts involve speculation on the future value of the underlying asset. These contracts are typically used in three ways:
- To arrange for the delivery or receipt of the underlying asset
- To benefit from price movements of the underlying asset
- To hedge against losses on other positions in the underlying asset or similar assets
To appreciate the relative advantages of options and futures, it’s necessary to understand how they work.
A Word About 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.
Leverage introduces additional risk, as can be seen if the stock price had declined to $80. Options and futures provide leverage, but to different extents.
Primer on Options
An option 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 option’s 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, which confer the right to buy the underlying asset, increase in value as the asset price increases. Put options give you the right to sell the asset at a set price, and they increase in value as the underlying asset’s price decreases.
Option Basic 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 third Friday of each month, although this varies with the type of underlying asset. Options can have lifetimes ranging from one week to more than a year.
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 XYZ Corp. stock with a strike price of $85 a share and one month left until expiration. The price of XYZ 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 Buyer’s Perspective
As the option buyer (known as the long position), you can experience three outcomes:
- 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 option’s money value derives from the fact that you can exercise and then sell the resulting shares. If you own an XYZ 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 or 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 buyer can never lose more than the premium amount.
Option Seller's 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 the option is 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 times the number of shares) for them, giving you a net loss of $275 minus $500, or $225. Your potential loss on a call is unlimited, as there is theoretically no limit to the asset’s price increase, and therefore the strike value.
Had the option been a put, it would have expired out-of-the-money, and your profit would equal your initial premium of $275. Your only source of profit is the initial premium, which explains why time value is a negative to you, since the sooner the option expires, the less risk that the option will gain value. The maximum loss on a put is the premium minus the strike value, since the price of the asset cannot fall below zero. For example, if you sold a put on XYZ shares and they subsequently fall to zero, your loss is $275 - $8,500, or $8,225. That is, as a put writer, you will be assigned the shares for $8,500, but because they are worthless, you won’t be able to recoup any of your loss by selling them.
Primer on 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 a futures contract has no additional premium – it simply is the value of the underlying asset. However, you must deposit a specified amount of money, called margin, when you buy or write a futures contract, and must continue to maintain margin in your trading account while you are in a long or short position, as specified in the futures contract.
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.
Traders close out a futures contract via offset: A long position sells an identical contract, and a short position buys an identical one. Contracts have terms from one month to more than one year.
Advantages of Options
Options have several advantages over futures:
- Less risk. Long option positions are less risky than futures and short option 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.
- Less expensive. Generally, option premiums are smaller than futures margins. For example, you might be able to buy an out-of-the-money call for well under $50, whereas you must put up the initial margin on a futures contract, often thousands of dollars.
- More leverage. Option contracts for a given underlying are listed with many different strike prices and expiration dates, meaning that there is a 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 on margin requirements.
- Flexibility. Long option positions are not obligated to exercise their options. Physically settled futures are always exercised at expiration.
Advantages of Futures
Advantages of futures contracts include:
- Efficiency. You don’t pay a premium to buy a futures contract, which saves you money when compared to the premiums you pay on options.
- Size. Futures contracts control more asset than the corresponding options. For example, a stock option controls 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).
- Daily cash settlement. The futures exchanges slice your ultimate gain or loss into daily installments. 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 account.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.