Differences Between Futures & Stock Options
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Differences Between Futures & Stock Options - Introduction
Futures and stock options are the two most widely
publicized leveraged derivative instrument in the world today. In fact, futures and options are the two most widely used hedging instrument
in the world as well.
This have 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 has 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. Even though futures and options are two different things, even since the invention of options on futures, that is, options with futures as their underlying asset, this distinction has been greatly blurred and made it all the more confusing for beginners to futures and options trading.
This tutorial shall explain
what
futures and options are and their main differences.
Differences Between Futures & Stock Options - 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 in the last
paragraph and is also why so many futures traders go broke every quickly if prices should move suddenly against them.
Differences Between Futures & Stock Options - What exactly is Stock Options Trading?
Stock options trading is the trading of stock options.
Stock options are financial instruments that give you the right to buy or sell certain
shares in the stock market. Using the 2 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 move 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.
Read more about Stock Options.
Differences Between Futures & Stock Options - Comparison
Here's a comparison of some of the main differences between Futures and Stock Options:
Premium
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.
Obligations
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.
Liability
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.
Expiration
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.
Versatility
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. Apart from
arbitraging, futures
trading is basically single directional (you make money only when price moves 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 become a stand-alone strategic investment.
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.
Read more about Futures Trading.
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