Both options and futures trading provide the opportunity to place leveraged bets on the movement of the stock market or commodity prices. The use of leverage lets traders multiply the gains of the price movements of the underlying instrument. In spite of these similarities, there are major differences between options and futures contracts, and those differences tend to attract traders to one type or the other.
Value of a Contract
The actual value of a futures contract and an option contract will be very different. A futures contract is for a significant amount of the underlying asset — worth perhaps $50,000, $100,000 or even $1 million — controlled with a much smaller margin deposit. An options contract gives the right to buy or sell the underlying asset at a specific price. The contract value is determined by the difference between the exercise price and the underlying asset price. As a comparison, an e-mini S&P 500 futures contract is valued at 50 times the S&P 500 stock index. With the S&P at 1,435, one e-mini futures contract is worth $71,750. A call option contract with the right to buy the S&P 500 at 1,435 has a value of about $2,000.
The price of a futures contract will closely match the value of the underlying instrument, with some adjustment for futures with delivery dates further into the future. For example, with the spot price of gold at $1,740, the price of the current and next month's gold future would both be within 50 cents of the spot price. An option's price includes time premium as well as the intrinsic value of the contract. A call option expiring next month giving the right to buy gold at $1,730 is priced at $30. With spot gold at $1,740, this option has $10 of intrinsic value and $20 of time premium.
Profit and Loss Potential
A major difference between the two types of derivatives is the risk/reward profile. The amount of money a trader can make or lose with a futures contract is basically the same — very large — in either direction. With an options contract, the risk/reward ratio is one-sided, depending on whether the option was bought or sold. Options buyers have a limited amount of money at risk combined with a large profit potential. Options sellers have limited profit potential against large potential losses.
Variety of Available Contracts
Although there are futures contracts covering a wide range of commodities and financial instruments, only a few different contracts will trade against a specific underlyilng asset. With options, a large number of contracts trade against an asset. First are separate puts and calls to cover the two sides of price movement. Then there will be a range of expiration dates. With each expiration date will be numerous strike prices. One popular and high-priced stock has options trading at 150 different strike prices. Options trade against thousands of individual stocks, hundreds of exchange traded funds, stock indexes and even futures contracts.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.