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The futures vs options debate never seems to break the stalemate — even the most experienced commodity traders often seem to ramble back and forth on this issue.
It's important to weigh your own risk tolerance before you take your stance in the debate. Use our guide to better understand both futures and options before you invest.
Understand the Risks
Both futures and options are derivatives and leverage instruments and are inherently riskier than trading stocks. Since both derive value from underlying assets, the price movements of the underlying assets determine the profit or loss on these contracts.
While your level of risk tolerance is equally a contributing factor, the bottom line is that futures are riskier than options. Futures are more sensitive to slight movements on the underlying asset than options are on the same amount of leverage and capital commitment. This makes them more volatile.
Leverage is a double-edged sword — an instrument is capable of profiting quickly, just as it's capable of losing money in an instant. In that case, futures trading can make you as much money as you can easily lose compared to trading options.
When you buy put or call options, the maximum risk is capped to the amount of money you invested in those options. You’ll suffer a misfortune if your prediction is entirely wrong and your options expire worthless — you won’t lose more than you had invested.
On the other hand, futures trading subjects you to unlimited liability and you must “top up” your daily losses at close of the day in what’s referred to as a margin call. Your daily loss will continue as long as the underlying asset continues to sail against the wind. You may even plunge into debt if you direct all your investment into a futures contract and lack the funds to fulfill the margin calls.
Even so, futures themselves aren’t technically “riskier” — it’s the ability to employ a higher degree of leverage that magnifies both the profit and risk. You can buy stocks on margin and get 5:1 leverage. Futures can give you 25:1, 50:1 or higher, so the slightest of moves will result in massive profits or huge losses depending on your investment.
What are Options?
An option is a contract between a buyer and a seller and that gives its owner the right — but not obligation — to buy or sell a financial product at an agreed upon price for a specific period. Option contracts are a cog in a larger group of financial instruments called derivatives and are available on financial products like equities, indices and ETFs.
The value of an option is derived from the underlying security, say a stock. When you trade stocks, you’re simply exchanging ownership in a publicly traded company. On the contrary, options contracts let you trade the potential or obligation to purchase or sell the underlying stock. Owning an option doesn’t guarantee ownership in an underlying asset, neither does it entitle you to any dividends.
Here are some key terms to help you understand how options work:
- Premium. An option buyer pays a premium to the seller — the price of the option. Sellers often quote the premium as the price per share, but since options contracts represent 100 shares of the underlying asset, you’ll typically pay 100 times the share premium for 1 options contract. Let’s say an option has a premium of $1, you’d need $100 to buy it.
- Strike price. Otherwise known as exercise price, it’s the price a seller is obligated to buy or sell at any time through the contract’s expiration date.
- Expiration date. All options contracts have expiration dates — the day the option ceases to trade. The “standard” expiration date for stock options is usually the 3rd Friday of the contract’s end month. There are also non-standard options that expire weekly.
There are 2 types of options: call options and put options. A call option gives you the right to buy a certain security at a specific strike price until the contract’s expiration date. A put option gives you the right to sell a certain security at a certain strike price until the contract’s expiration date.
What are Futures?
Futures are a derivative contract agreement to buy or sell a specific security or commodity asset at a predetermined future date. In a futures contract, the buyer and seller strike a deal on the price, quantity and the future delivery date beforehand.
In a futures contract, you can take the position of a buyer or a seller. If the price goes up, the buyer will reap profits since he or she bought the asset at a lower price. If the price goes down, the seller takes profits since he or she sold at a higher price.
To put this into perspective, the S&P 500 futures contract, which follows the S&P 500 index, and has a multiplier of $250. This implies that every index point the S&P 500 index moves up or down is worth $250.
If you take a sell position with a predetermined future index value of 2,000. Should the index rise 10 points to 2,010 by the end of the trading day, you’ll lose $2,500 (10 index points x $250). If the index drops 10 points to 1990, you’ll gain $2,500.
Unlike an options contract that becomes worthless upon expiry, when a futures contract expires, a buyer is obliged to buy and receive the underlying security while the seller is obliged to provide and deliver the underlying security. Common types of futures include:
- Commodity futures let you speculate the future prices of all commodities, including natural gas, gold and orange juice.
- Financial futures let you speculate on the future prices of financial assets like financial indices, stocks, foreign currencies and treasury bonds.
Retail traders don’t typically hold a futures contract until it expires. You can close out of your contract when the difference between the contract price and the prevailing market price makes you a profit.
You’re only required to deposit a small portion (known as the initial margin) of the contract’s total value to enter a position on a futures contract. Futures exchanges set the initial margins and may range from 4% to 15% of a futures contract’s total value.
Pros and Cons of Options
|Leverage. An options contract can provide cheaper exposure to a security than trading shares outright, therefore magnifying your profits if the stock moves.||Expiry. One downside about trading options is that they often expire worthless, so you could easily lose what you paid for the options contract|
|Less expensive. Option premiums are usually smaller than futures margins||Taxation. Except in rare circumstances, options profits are taxed at the short-term gains rate. Commissions, particularly on weekly options, also tend to be higher|
|Flexibility. You’re not obliged to exercise your long options contract positions||Trading restrictions. Your broker must approve you to trade options, not forgetting the minimum $2,000 balance you must maintain.|
Pros and Cons of Futures
|Leverage. Most brokers set the required margin amount between 3% to 10% of the underlying contract value. This leverage creates the potential to reap higher returns relative to the amount of money invested.||You may take more risk. Due to the low margin requirements needed to trade futures, you may leverage more and similarly stand to lose more money|
|Diversification. Futures let you diversify your portfolio through direct exposure to underlying commodity assets and stocks. You may also access assets not available in other markets.||Exposed to unlimited liability. If the market price of an asset goes against your prediction, you’ll continue to lose money until your maintenance account is drained or close your position altogether.|
|Tax benefits. Futures traders enjoy tax benefits since profitable futures are taxed on a 60/40 basis: 60% as long-term capital gains and 40% as ordinary income.||You could lose too early. Futures brokers tend to adjust traders accounts daily. A volatile market movement could eat into your maintenance account and close your position on a contract too soon. You may end up missing out if the price swings in your favor.|
|No pattern day trader rule. Pattern day trader rules don’t apply to futures traders|
If you had to choose between trading options and trading futures, your main attraction would be options since you can’t lose more than your initial investment. Trading options may also be a more prudent approach, particularly if you take advantage of option spread strategies. Bear put spreads and bull call spreads can boost your odds of success if you intend to hold for a longer-term trade.
Futures often involve a high degree of risk since they are highly leveraged, with a relatively small amount of money controlling assets of greater value. This means that the amount you can potentially lose is unlimited and may exceed your original deposit. Some market conditions may also make it difficult or impossible to sell or hedge a position.
As risky as futures are, they generally have 2 uses in investing:
- Hedging/risk management. Institutional investors who buy or sell futures contracts with the intention of receiving or delivering the underlying commodity can use them for hedging purposes. This is often a way to help manage the future price risk of the commodity on their investment portfolio.
- Speculating. Futures contracts are generally as liquid as options and can be bought and sold up to the time of expiration. This is a crucial attribute for the speculative traders and investors who don’t own or wish to own the underlying commodity. You can buy or sell futures to express an opinion about — and possibly profit from — the direction of the market for a commodity.
Ultimately, margin trading involves charges and risks, including the potential to lose more than your deposits or the need to deposit an additional collateral in a falling market. Before getting into margin trading, be sure to establish the right trading strategy given your investment objectives, experience, risk tolerance and financial situation.
Best Online Brokers for Options
Take a sneak peak at our top picks for online brokers for options. Compare what each offers to find the right platform for your needs.
Best Online Brokers for Futures
Don’t spend so much time identifying a futures broker on your own. Establish your priorities, and use Benzinga’s list to find the best online brokers for futures.
Best Options and Futures
Here’s the best of both worlds if you’re looking to deep your feet into both options and futures.
|Best Options||Best Futures|
|3M options||Eurodollar futures|
|NextEra Energy options||E-mini S&P 500 futures|
|Baidu options||Crude oil futures|
|Zoom options||10-year treasury note futures|
|Progressive options||Micro E-mini S&P 500 index futures|
Try a Few Derivative Instruments Today
As risky as derivatives and leverage instruments are, it’s not all doom and gloom — you can use options and futures to hedge risks, generate income and speculate the market. The crucial element is to understand how to manage the risks of using high leverage.
With a solid trading strategy, you can reap great profits using these instruments, much greater than with other asset classes. You may also lose quite as much without robust risk management techniques.
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