Futures and options are both very profitable derivatives. They
offer various benefits that are distinct, even if the two seemingly appear the
same. However, many investors are actually not aware of the main differences of
futures and options.
Before we tackle their main differences, let’s first define
what derivatives are exactly like.
Futures and Options: What are Derivatives?
When we talk about derivatives, we’re referring to financial
securities that sport a value that is based or “derived” from a group of asset
or underlying assets.
The derivative is a contract sealed between two or more
parties, and they seal the deal based on the underlying assets, whose
fluctuations dictate the price of the derivative.
Stocks, bonds, commodities, interest rates, currencies, and
market indexes are the most common underlying assets used in derivatives.
Moreover, you can trade derivatives over the counter or on
an exchange. What’s the differences between the two?
Over-the-counter derivatives are unregulated. These types of
derivatives account for the majority of all derivatives in the market. Meanwhile,
exchange-traded derivatives all follow some criteria, which make them
standardized.
The Main Differences of Futures and Options
Futures and options are both derivatives, but they sport
distinct traits suitable for different kinds of investors. The following
explains the main differences between the two.
Rights and Obligations
If you choose to trade futures, both you and the buyer or
seller should settle the futures contract no matter how the underlying asset
behaves. This is your obligation as a futures trader.
Meanwhile, this is the case for options traders. If you choose
to trade options, you also have the right to buy or sell the underlying asset. The
difference is that you are not obliged to do this if you don’t want to, hence the
name “options.” In addition, the option seller must comply with what the option
buyer wants to do.
Risks and Returns
For futures contracts, you can gain or lose unlimited amounts
of money. Your likely gains or losses could go way beyond the initial margin
paid.
For options contracts, the potential gains and losses are
not the same. The potential gain you have if you buy an option can be
unlimited. However, your risks as a buyer are only limited to the premium you
have paid. Since you have to pay a premium, your potential gain is smaller than
that of a futures trader.
Meanwhile, your profits as an option seller is only limited
the premium you have received. Considering that the option seller must comply
with the buyer’s decision on exercise, your losses may exceed the amount of
premium you have received.
Read further: Breaking Down Risk Management
Requirements on the Margin
If you are trading futures you must pay an amount for the
margin deposit to open a buy or sell position for the contract. Meanwhile, an
options trader only has to pay a premium once the contract kicks off and he or
she doesn’t have to post a margin.
Final Word
As a trader, you have to know these fundamental differences
between futures and options contracts before you dive into them. The best way
to learn deeper and more useful knowledge about them, however, is to actually invest
in them.
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