Options vs Futures Contracts

When it comes to financial derivatives, there are a few different types of instruments that can be traded. The most popular type of derivative is the options contract. An options contract is an agreement between two parties that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date.

Options

Call Option

A call option is an agreement between two parties that gives the purchaser the right, but not the obligation, to buy an underlying asset at a specified price within a specified time period. The asset may be a stock, bond, currency, commodity, or index. The price at which the underlying asset can be purchased is called the strike price, and the time period is known as the expiration date.

The party who sells the call option is known as the writer, and the party who buys the call option is known as the holder. The holder pays the writer a premium for the right to purchase the asset. If the holder does not exercise the option before the expiration date, the option expires and the holder forfeit the premium.

There are two types of call options: American-style and European-style. American-style call options can be exercised at any time before the expiration date, while European-style call options can only be exercised on the expiration date.

Call options are often used as a hedging tool. For example, a company that is worried about a decline in the price of its stock may purchase a put option, which gives it the right to sell the stock at a specified price. If the stock price does decline, the company can exercise the option and sell the stock at the higher price, offsetting some of the loss.

Put Option

A put option is a contract that gives the buyer the right, but not the obligation, to sell a stock, commodity, or other asset at a specified price on or before a certain date.

Put options are used as a form of insurance to protect against potential losses in the underlying asset. For example, a buyer of a put option on a stock index may use the option to hedge against a decline in the stock market.

The price at which the put option can be exercised is known as the strike price. The premium is the price the buyer pays for the option. The expiration date is the date on which the option expires and can no longer be exercised.

When the underlying asset is a stock, the put option gives the holder the right to sell the stock at the strike price on or before the expiration date. If the stock price falls below the strike price, the option will be in the money and the holder can exercise the option to sell the stock at the strike price.

If the stock price is above the strike price at expiration, the option will be out of the money and will expire worthless.

The buyer of a put option is taking a short position in the underlying asset. The seller of a put option is taking a long position in the underlying asset.

When the option is exercised, the buyer of the put option will sell the underlying asset at the strike price. The seller of the put option will buy the underlying asset at the strike price.

The buyer of a put option has the right to sell the underlying asset at the strike price on or before the expiration date. The seller of a put option has the obligation to buy the underlying asset at the strike price if the option is exercised.

Futures

A futures contract is an agreement to buy or sell an asset at a later date at a price agreed today. Futures contracts are used as a way to hedge against future price movements or to speculate on the future price of an asset.

Futures contracts are traded on exchanges and are standardized so that each contract is for a specific quantity and quality of the underlying asset. This makes it easier to trade and to know what you are getting. For example, a corn futures contract might be for 5,000 bushels of corn delivered in May.

The price of a futures contract is not the same as the spot price of the underlying asset, but is rather the price at which the contract can be bought or sold at a later date. The price of a futures contract is determined by the market and can change daily.

When you buy a futures contract, you are buying the right to buy or sell the underlying asset at a later date at a price specified today. If you think the price of the underlying asset will go up, you will want to buy the contract. If you think the price will go down, you will want to sell the contract.

If you buy a futures contract and the price of the underlying asset goes up, you can sell the contract at a profit. If the price goes down, you will have to sell the contract at a loss.

When you sell a futures contract, you are selling the right to buy or sell the underlying asset at a later date at a price specified today. If you think the price of the underlying asset will go down, you will want to sell the contract. If you think the price will go up, you will want to buy the contract.

If you sell a futures contract and the price of the underlying asset goes down, you can buy the contract back at a lower price and have a profit. If the price goes up, you will have to buy the contract back at a higher price and will have a loss.

Futures contracts are often used by investors to hedge against price movements in the underlying asset. For example, if you own a stock, you might buy a futures contract to protect yourself against a fall in the price of the stock. If the stock price falls, the value of your contract will go up, offsetting some of the loss in the value of your stock.

Futures contracts can also be used to speculate on the future price of an asset. For example, if you think the price of gold is going to go up, you might buy a gold futures contract. If the price of gold goes up, you will make a profit on your contract. If the price of gold goes down, you will have a loss.

Futures contracts are traded on exchanges, and the price of a contract is determined by the market. Futures contracts are a way to hedge against future price movements or to speculate on the future price of an asset.

Option vs Futures Contract

The primary difference between futures contracts and options contracts is that futures contracts are binding, while options contracts are not. This means that if you enter into a futures contract, you are obligated to buy or sell the underlying asset at the predetermined price, on the predetermined date. If you enter into an options contract, you are not obligated to buy or sell the underlying asset, and can choose to do so at your discretion.

Another difference is how the prices are affected by time. In options trading, time is one of the greeks called theta and is part of the calculation of an option's value. Every day an option contract gets closer to its expiration date, it loses more value. This is not the case for futures contracts as they hold value at expiration. Options, on the other hand, lose all of their value at expiration. When a futures contract expires, it is settled (either in cash or the commodity itself) and is paid to the holder.

The final major difference between the two is that futures contracts have unlimited potential risk, regardless if you buy or sell them. A crude oil contract could be bought at a price of $100 and then the price could drop below zero, similar to what happened in 2020. However, when you buy a call or put option, the most you can leave is the amount you paid for the option. Selling options can also present unlimited potential risk for the seller, for the same reason mentioned above for futures contracts.

Both of these types of derivatives are risky, leveraged assets and should be traded with caution.