Futures are contracts that obligate the contract holder to buy the underlying assets at an agreed-upon price in the future. The futures contracts are a hedging tool. They are mainly used to hedge against commodities. These contracts provide a stable future price to the buyer of the commodity and allow the trader on both sides to lock in the prices of a commodity.
For instance, a farmer who has had a great corn crop and is thinking that prices would fall as the market gets flooded with corn. So, he would go to the futures trader who would pay him the current price of corn in the future when he sells the crop. The farmer is charged a small contract fee, but he knows for what price he will sell in the future, and then he can make his plans according to the money he will get in the future.
What is options trading?
Options trading allows the contract holder to, but not obligated to buy the underlying asset in the future at an agreed-upon price. It can be a commodity or financial asset such as stock or bond. This is also a tool used by investors to hedge against any risk in the market and to make money as well – speculation.
The option contract is also a cheaper option than buying the asset outright as it gives the investor an option to buy the underlying asset in the future at an agreed-upon price. While options trading can be used for commodity hedging, it is mainly used for stocks hedging.
Let’s take an example of Stock A, in the present, the stock is trading at $10, but I believe it would go up to $12 in a month, so I buy an option on the stock to buy it in one month at the current price. Now, one month goes on and the stock is now worth $13, so I exercise my option contract and buy the stock at $10. I immediately sell the stock at $13 and net the difference. I paid $1 for the options contract. So, my total profits are $2.
Now, suppose that stock had fallen to $7 instead of going up according to my predictions. I would just let the options contract expire and pay the $1 price of the contract instead of paying $3 if I had bought the stock outright.
Difference Between Futures and Options
The main difference between Futures and Options are as follows:
i) The future contract is an obligation to buy an underlying asset in the future whereas the options contract is not an obligation to buy the underlying asset in the future.
ii) Futures are mainly used for commodities, whereas options are mainly used for stocks or bonds.
iii) In options trading both the buyer and seller are exposed to maximum liability, whereas in the futures contract only the buyer is exposed to the maximum liability.
iv) Options are more complex financial products than Futures.
Similarities Between Options and Futures
As there are differences between options and futures, there are also many similarities between the two. The similarities are as follows:
i) The options and futures are both hedging contracts.
ii) Both allow the contract holder to buy the underlying security in the future at an agreed-upon price.
iii) Both options and futures contracts expose maximum liability to the buyer of the contract.
iv) Both options and futures contracts help to protect the investors in a highly volatile market.
Main types of Future Contracts
There are two main types of Future Contracts. These both are shown in figure 1 below:
Figure 1: Two types of Future contracts
The two main types of futures contracts shown in figure 1 are commodities and financials. Both of these are explained in detail below:
Commodities futures contract
It is as the name implies a futures contract for commodities. This future contract is primarily for commodities. The future contracts are mainly used for commodities.
Financials future contract
The financials future contracts are used for financial products such as stocks or bonds. The future contracts are not used as much for financials.
Main types of Options contracts
There are two main types of options contracts which are shown in figure 2 below:
Figure 2: Two main types of options Contract
The two main types of option contracts depicted in figure 2 are Call and Put Option. These are explained in detail below:
Call Options Contract
Call options contract basically allows the buyer to buy the underlying asset or security in the future at the present price. This is not an obligation for the investor, but an option. The call option is used by the investor when the investor is expecting the price of the asset to go up. By locking in the asset at the current price, it allows the investor to profit from any rise in the future prices of the asset. But, the investor can choose not to buy the asset if the price of the asset falls.
Put Options Contract
The put options contract allows the investor to sell the underlying asset in the future at the current price. It is by no means an obligation, but an option. If the price of the underlying asset rises, the investor can simply choose not to buy that asset.
The put option is practiced when an investor thinks that the price of an underlying asset will fall. The investor is looking to profit from the falling price of an asset. This is also called shorting the stock. The investor can maximize profit without taking on any extra losses.
The futures and options contracts have their own advantages and disadvantages. They carry the potential to maximize profits, but also at the same time expose the investor to a great loss. Any trader who is thinking of using options and futures must first fully understand the risk these contracts carry.