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Futures and Options Trading

Futures and Options Trading - How They Are Different

Futures and options trading are two of the best known derivatives used on the financial markets today. But each of them have their own peculiar set of characteristics, which must be clearly understood before an aspiring trader risks precious funds on them.

If we were to highlight the essential difference, conceptually speaking, between a futures and options trading contract, we would explain it this way:-

An option contract gives the buyer the right but NOT the obligation, to purchase an underlying asset at an agreed price, up to an agreed expiration date. A futures contract on the other hand, creates only an obligation to make, or take, delivery of the underlying asset at an agreed future date.

So let's see how futures and options trading works in practice.

How an Options Contract Works

Imagine you're about to buy an options contract for an underlying stock. The current market price of the shares is $30 and you believe it could rise to $35 within the next month. So you purchase an at-the-money $30 call option with an expiration date two months away. This gives you the right, but not the obligation, to "call" on the market to sell you the shares at $30 any time you choose to exercise it, up to the expiration date.

The price of the option contract is quite complex, but one of its main features is this thing called the "delta". The delta is the rate at which your option contract will increase or decrease in value, in proportion to a change in the value of the underlying stock. For at-the-money contracts, the delta is usually 0.50 which means that for every dollar move in the underlying, the option contract changes by 50 cents. As the call option becomes further in-the-money, the delta increases to a maximum of 1, at which time, assuming it continues in its present direction, its value will increase dollar for dollar with the underlying asset.

If the option contract goes out-of-the-money, i.e. no intrinsic value, the delta decreases, leaving "time value" as the only component of the option's value. This "time value" is an expression in financial terms, of the probability that the contract will be in-the-money by expiration date.

When you buy an option contact, the maximum amount you can ever lose is the amount you originally paid for the option premium. This is one reason they are so popular - the perceived limited risk.

How a Futures Contract Works

Futures are more commonly traded on commodities than stocks, but to highlight the differences, let's assume the same $30 stock scenario in our example above - only this time we're going to purchase a $30 futures contract, to be settled two months out.

Our futures contract obligates us to purchase the stock at $30 in two months time. If the stock is then trading at $40 we have made a $10 profit per share. But if it has dropped to $20 by that time, we must still purchase it at $30, effectively losing $10 per share.

If we believe the stock is about to fall, we could sell a $30 futures contract under the same terms. This means that if the stock has fallen to $20 by settlement date, we still have the right to sell it to the clearing house for $30, thus making a $10 profit. The reverse applies if the stock should be above $30 at settlement date.

To accept this future obligation, we put up some money and this is called a 'margin'. The margin is usually between 5 and 15 percent of the value of the underlying asset, so let's take 10 percent for our example. We buy a futures contract for 1,000 x $30 shares. The value of these shares would be $30,000 but we only put up $3,000 or 10 percent, for the contract.

Futures and Options Trading - Differences in Risk

Unlike an option contract, whichever way the underlying stock price moves once we enter the position, our futures contract will either increase or decrease in value, dollar-for-dollar, based on the value of the assets covered by the contract.

So continuing with the above example where we have purchased a futures contract on a $30 stock, should the stock price drop by $5 tomorrow, our $30,000 asset is now only worth $25,000. This $5,000 loss will be reflected in the futures contract and you'll notice that the loss exceeds our initial margin of $3,000. Our broker will then contact us and want an additional $2,000 from us to cover the difference, if we don't have it in our account already. This is called a "margin call". If our initial margin had only been 5 percent, or $1,500 then our broker would be asking for the $3,500 difference.

So you can see that, unlike options where our risk is limited, a futures contract can hurt us badly. Why? Because we have purchased an obligation but not a right. An option buyer is never subject to margin calls.

If a futures contract is hurting you, you can exit the obligation before settlement date by offsetting your position. You can do this by either buying back the contract for a loss, or if you want to limit your risk, sell (go short) another one for a different settlement value, e.g. $27 in our example. You would then hold a 'buy' and a 'sell' position with a $3 difference. For this reason, futures speculators often take out 'spread' positions - a combination of long (buy) and short (sell) positions, to limit their risk and avoid margin calls.

Options prices include a "time value" to expiration component, whereas futures contracts simply reflect the changing obligation based on the value of the underlying asset.