What are the Differences between Futures and Options Trading?


Futures and stock options are the two most widely publicized leveraged derivative instrument in the world today. In fact, futures and options can be considered as two most widely used hedging instrument in the world as well. The obvious similarity has inevitably led many investors into thinking that futures and stock options are the same thing. In fact, there have been laymen investors referring to both instruments collectively as "Options Futures". Nothing can be further from the truth. Futures and options are two different things and futures trading really have nothing to do with options trading. Futures and options serve different needs in the capital market and will forever be important elements on their own in every well diversified portfolio. This post shall explain what futures and options are and their main differences.


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What exactly are Futures? 

Like stock options, a futures contract is an agreement between a buyer and seller of an underlying asset. In a futures contract, the buyer agrees to buy and the seller agrees to sell the underlying asset at a price agreed upon now at a future date. Like stock options, futures contracts are standardized contracts and traded publicly in an exchange. Up to this point, a futures contract sounds a lot like a call option, right? Well, that's just about where the similarity ends. Buyers of the futures contracts put up a fraction of the price of the underlying asset when the contract is entered upon. This upfront payment is like the downpayment you pay when buying a house, which means that the futures contract itself does not come with a premium. Buyers and sellers of futures contracts are also obligated to fulfill the futures contract agreement upon expiration but not buyers and sellers of options contracts. Because of this obligation, both parties are exposed to unlimited liability when prices move against their favor.

In futures trading, price differences are settled daily, which means that if prices move against your favor, you may be required to topup your trading account in what is commonly known as a "Margin Call". This also means that as long as prices continue to move against your favor day after day, you will be required to topup every single day. This is the unlimited liability that we talked about earlier and also why so many futures traders go broke every quickly if prices should move suddenly against their favor.

What exactly is Stock Options Trading? 

We already explained in the previous posts the meaning and main characteristics of the option, but we will briefly underline the main points for the further comparison. Stock options are financial instruments that give you the right to buy or sell certain shares in the stock market. Using the two kinds of stock options - Call Options and Put Options -  options traders are able to profit when the underlying stock goes up or down and even when it is trading sideways.

In options trading, all you can lose is the amount of premium paid towards buying the stock options when prices move against your favor. If you buy a contract of call options for $100, all you can lose is $100 if the stock moves against your favor. This is unlike the unlimited liability facing futures traders. This is also what makes options trading safer than futures trading for most beginners.

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Comparison Futures and Stock Options
Here's a comparison of some of the main differences between Futures and Stock Options:

While you pay a fee called the "premium" when buying stock options, there are no premiums to be paid in a futures contract. The initial amount of money (known as "Initial Margin") paid when you buy a futures contract is a fraction of the price paid for the underlying stock.

Buyers of stock options are not obligated to exercise the rights to buy the underlying stock at all while buyers of futures contracts are obligated to buy the underlying stock from the seller of that contract upon expiration.

Buyers of futures contracts are exposed to unlimited liability should prices move against them while buyers of stock options lose only the amount of money used to purchase those stock options. Only writers of stock options are exposed to unlimited liability, not buyers.

Buyers of futures contracts are obligated to buy the underlying asset (for physically delivered futures contracts) upon expiration of the contract no matter what price the underlying asset is. Buyers of options contracts can allow the options to expire worthless if the options are out of the money.

Options trading is a lot more versatile than futures trading as the unique combination of call options and put options along with the premium on each contract made it possible for options strategies that profit in all directions to be created. Apart from arbitraging, futures trading is basically single directional (you make money only when price move in one direction).

By now, it should be clear that futures and stock options trading are two totally different things with their own trading characteristics. Futures trading is an important risk management and speculative technique while options trading has evolved to becoming a strategic investment on its own. Futures should never be made a replacement for stock options trading and stock options trading cannot replace Futures as well. Both trading instruments serves different purposes and should find their place in every well diversified portfolio.

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