Futures Versus Options: Pros, Cons, and What You Should Know

Mar 30, 2022

Futures Versus Options: Pros, Cons, and What You Should Know

The stock market is full of terms that you should familiarize yourself with. For example, do you know what derivatives are?
Derivatives are financial instruments that obtain value from something else. There are four main types of derivatives: futures, options, forwards, and swaps.
Futures and options are the most common derivative types for investors, and weighing the advantages and drawbacks of futures vs options can be a complex subject. Let’s start by defining each term.

What Are Futures?

Wouldn’t it be nice if you could gaze into a crystal ball and know the price you could buy or sell in the future? Especially if you could mitigate risk?
Futures are like that crystal ball. Also referred to as futures contracts, this type of derivative involves two parties in every transaction.
The parties agree to buy and/or sell an underlying asset at a future date at a pre-determined price via a standardized contract. The contract is very specific, including:
  • Asset quality
  • Asset quantity
  • Date of delivery
  • Time of delivery
Trading futures is common with commodities like corn, barrels of oil, or precious metals. However, these derivatives have gradually expanded beyond commodity markets  to include stock options and mutual funds as well.
Aside from commodities, stocks, and bonds, other types of futures contracts include currency futures, interest rate futures, and ETF (exchange-traded funds) futures.

Example of a Futures Investments

Let’s look at an example.
An investor seeks to purchase gold via a futures contract. They agree to purchase 100 troy ounces of gold at the current contract price, and the seller agrees to deliver it no later than the specific date listed in the contract.
The investor hopes that the price will fluctuate in their favor by the time the contract is fulfilled. They watch the minimum price fluctuation, or tick size ( in this case, measuring $0.10 per troy ounce) with anticipation.
If the price increases or decreases changes by five ticks (or $0.50 in this example), the investor is either at a loss or a gain of $50.00.

Buying and Selling Futures

Interested in buying or selling futures? There are two types of investors that futures contracts attract: hedgers and speculators.
As a hedger, you are looking to mitigate the movement of an unfavorable price of a security, minimizing uncertainty from the equation. As a speculator, you are more interested in making a quick profit.
To get started in the futures market as either type of investor, you’ll need to open a margin account. The best place to start is opening a brokerage account with a reliable firm.
Within a brokerage firm, a margin account is different than a cash account, although you can have both at the same time. The margin account allows for your broker or lender to deposit funds used to purchase securities.
Before opening a margin account and beginning to trade, you’ll want to determine:
  • The minimum margin requirements (how much is your initial deposit to open the account)
  • The initial margin (how much you are able to borrow)
  • The maintenance requirements (what will be expected of you to manage the account)
Margin accounts come with their own level of risk. For example, margin accounts may:
  • Require investors to deposit their own cash on short notice should large losses occur
  • Force the sale of securities, especially when prices are declining
  • Involve a change in brokerage requirements

When Should You Consider Futures?

Futures may not be for all investors, especially not for beginners. They can be rather complex. Many investors use them to:
  • Hedge against future risk
  • Forecast future pricing
  • Advance their investment portfolios
  • Enter and exit the market efficiently, as they are highly liquid

What Are Options?

Options are non-binding as opposed to futures contracts, which require investors to settle into a contract. Sure, there are still options contracts, and they do still create an agreement between the buyer and seller — but the option buyer is not required to fulfill it.
At the time of purchase, the only liability associated with an option is the premium paid. Since the options traders are not locked in, the agreement does not need to be executed at specified prices or times.
Instead, traders can watch price movements and wait for the specific price that is beneficial to them. Investors typically watch the strike price, or exercise price, of an option.
The definition of strike price varies slightly depending on whether you are referencing a call or a put option, but it basically means the price that the option is “exercised”.
  • For call options, the strike price is the price the underlying asset can be purchased for.
  • For put options, the strike price is the price the  asset are eligible to be sold for.

Example of Options Investing

An investor purchases a call option for crude oil at $50 per share, which is set to expire in three months. The investor has the choice of holding onto the option until the expiration date or purchasing it if the price rises during that time.
If the price per share is trading at $60 per share within the three month time span, the investor can exercise the option, purchasing it at the agreed-upon value of $50 per share.

Finding the Right Strike Price

As the investor, what is your objective with options trading? Do you want to add growth to your investment portfolio, or are you strictly looking for added income from different types of options? These are but two of many questions to ask when determining the right strike price.
Finding the right strike price increases your chance of success. There’s no guarantee that a profit will follow; its purpose is just to guide your trading strategies and steer you towards the optimal outcome.
Here are two strike price analysis tools available to investors:
  • Greeks: Mathematical calculations used to measure how various factors impact results, Greeks assess factors like the timing of expiration, volatility, price trends, and more.
    • Greeks focus on the use of a Delta ranging from -1 to +1, where the greater the Delta is, the more costly the option is anticipated to be.
  • Probability calculator: Considered a more definitive measure than that of the Delta, the probability calculator is used to tell the story of the underlying asset’s price value.
    • The calculator is considered a more successful method, as it allows the user to set parameters like target date, price, and level of risk.
When using different tools, investors should be sure to consider all of the fundamental factors impacting strike price. This includes:
  • Length of the agreement: Time plays an important role. The longer the agreement, the greater the probability of the option trading above the strike price. However, this kind of agreement may cost more than an option with a shorter expiration date.
  • Liquidity: If trading frequently, watch for small bid-ask spreads so that trading costs don’t exceed your potential gain.
  • Moneyness: Are you in the money (ITM) or out of the money (OTM)? When ITM, the strike price has been met or exceeded.. When OTM, the strike price has not yet been met.

Call Options Versus Put Options

Both call and put options fall under the category of non-binding agreements, but they work differently in the market. A few of the key differences include the following:
  • Call options focus on the buying of the underlying asset, whereas put options focus on the selling.
  • Call options are favorable when the value of an asset is on the rise, whereas put options are favorable if the values are decreasing (binding the sale of an asset at a pre-determined price).
  • Call options require the buyer to pay a premium to the seller, whereas the sale of a put option requires the seller to deposit margin money to the stock exchange.
To summarize, call and put options are fixed scenarios. They differ in when they are utilized — call options at the time of purchase and put options at the time of sale.
Think of put options as a form of insurance, protecting you as the put option buyer from taking a loss on an investment should the underlying asset tank in its value while you own that put option contract.
On the other hand, think of call options as a security deposit. You may not have put the funds down upfront, but you have the right to exercise the option at the fixed price during the pre-arranged timeframe.

Who Is the Option Writer?

The option writer, or option seller, is associated with both call and put options. This is the investor responsible for initially opening the option.
When the buyer of an option is ready, the premium is paid to the option writer.
For a call option, the writer may or may not own the underlying asset. If they do not own it, the transaction is considered to be uncovered, or naked. This assumes more risk to the writer than that of a covered option.

Leading Differences Between Futures and Options

Futures and options both operate on agreements. The former is binding; the latter is not.
There are other key differences involving the risks associated with entering into either type of agreement.
  • Futures and options are traded at different times:
    • Futures are traded Sunday through Friday from 6PM EST to approximately 5PM EST. The closing time is dependent upon the type of security.
    • Options are traded Monday through Friday from 9:30AM EST to 4:00 PM EST, following the same schedule as stock trades.
  • The underlying assets of futures are most commonly commodities, whereas underlying stocks are a more popular choice for options.
  • Futures contracts carry a higher level of risk  than options because both the buyer and seller must follow through with the agreement by the expiration date. With options, risk to the buyer of the contract is limited to the amount of the premium paid.  The seller may have to deliver shares or money (in the case of a call contract) or buy shares/pay money (put contract).
  • Time decay is not factor with futures contracts, primarily because the contract must be executed by a specific date. On the other hand, time decay is a factor with equity options (but not index options) and accelerates as it gets closer to the expiration date.

The Bottom Line

You may feel like you are riding a merry-go-round with futures and options. Prices are bound to fluctuate, moving up and down, as you race against the expiration date.
Whichever derivative option you choose, remember that each has its own level of complexity and risk. Futures and options are better suited for well-seasoned market investors than beginners, but they can be a valuable learning method for all experience levels.
LifeGoal Investments is here to help you understand the importance of investing. We’re ready to help you strategically build a financial portfolio so that you can focus on today and be prepared for the future.