Futures vs. Options

Futures and options are two of the most widely traded derivatives, used by private traders and investment funds the world over to provide much needed flexibility in leveraged trading.  In an ideal world, a trader will make use of both instruments to varying extents, building on the strengths of each distinct instrument to enhance the available returns and provide opportunities for hedging against other leveraged and unleveraged positions. But being in a position to use both futures and options as part of a trading portfolio requires a solid working knowledge of the make-up of both instruments, and the key differences of each in order to understand which instrument is best in a given investment scenario.

Futures are fundamentally obligations.  They are contracts that specify the time of delivery, set the price for delivery and specify the nature and quantity of assets to which they relate.  On expiry of a futures contract, the bearer is compelled to follow through on the transaction, either on a physical transfer or cash-settled basis.  This means that for the bearer of futures, losses are not limited to the extent of their outstanding position – they are in fact open to potentially infinite losses given the compulsion to buy the specified assets at a specified price point.

As a result, futures will suffer price decay as they near their expiry date and their value naturally diminishes with all things being equal on the approach to that date, but nevertheless futures contracts provide traders and manufacturing businesses alike with the ability to lock in guaranteed prices for the underlying asset, to be delivered at the defined future point.

Options on the other hand, while appearing relatively similar, are in fact distinct in a number of important aspects.  Unlike futures, options are rights in an underlying asset.  The trader is not compelled to execute the trade, but is merely acquiring the right to do so at a capped price.  There is no defined end date for options, but like futures they are freely tradable on exchanges to provide traders with the ability to call in their rights relative to underlying asset price movements at some undefined future point.

Options are also unburdened by unlimited losses.  Because options may or may not be used (i.e. it’s optional), as opposed to futures which must be deployed on their expiry date, traders can either exercise their rights for maximum gains when conditions suit them, or they can accept a much smaller loss and allow their futures position to go unused – the choice depends on the financial outcome that’s most suited to the trader, but effectively caps the downside while allowing for an unlimited upside.

It is also possible to buy options on futures contracts – known in trading lingo as futures options.  Futures options are effectively derivatives on a derivative, allowing enhanced leverage on already highly leveraged futures contracts.  Futures options give the trader the right to acquire futures contracts at a stipulated price at some later date if they wish, and as such they can be used to deliver significant profits over the long-term.

Options are also immune from price decay, given that they don’t have a set expiry date, and so they can be resold or kept for as long as your trading account can bear the financing costs and margin of holding.

Options and futures are both widely traded instruments but they are significantly different in their features and in the pros and cons they bring to the table.  For the eager trader, trading one or the other is recommended (as opposed to a pluralistic approach) until you become sufficiently confident in the features of both instruments to build them in to your portfolio.  With futures and options both in the armoury, the opportunities for profitable trading are significantly increased, giving the trader the flexibility to make more customised trading decisions.

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