Futures Options Explained

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What are futures and options, and how do they work?

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Before coming to the details of futures and options, let’s dig into the basics first.

1. What is a share?
To put simply, a share is a part of ownership of business. If you purchase a share of Google, you own a percentage of it’s business (although a very small one).

2. Why shares?
Well, let’s look at an example.

Martha owns a bakery. The bakery works good and is making good profits, let’s say $90000 per year. Now, since, the business is profitable, it is an income, so she will have to pay taxes and deductions. Her net profit is say $60,000. The bakery also owns a property of $400000 ma.

Difference Between Futures and Options

May 16, 2020 Posted by Admin

Futures vs Options

Options and futures are derivative contracts that allow the trader to trade the underlying asset and obtain benefits from changes in prices of the value of the underlying asset. Both options and futures contracts are used for hedging, where these contracts can be exercised to reduce the risk associated with the price movements of an asset. Options and futures contracts are both equally important to any trader, and their use will depend on the purpose for which they are required. The following article clearly explains the two and provides a clear distinction between them.

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What is an Options Contract?

An options contract is a contract that is sold by the option writer to the option holder. The contract provides the trader with the right and not the obligation to buy or sell an underlying asset for a set price during a specified period of time.

There are two types of options; a call option that gives the option to buy at a specific price and a put option, which gives the option to sell at a specific price. A buyer of an option would want the price of the asset to go up so that the trader will be able to exercise his option and buy at a lower price currently.

For example, an asset X is valued at $10, and the option buyer buys an options to purchase the asset at $8. If the price of the asset increases to $12, the trader can exercise his option and purchase the asset at a lower price of $8. A seller of an option, on the other hand, would want the price to up so that he may exercise the option and sell at a higher price.

What is a Futures Contract?

Futures contracts are standardized contracts that list out a specific asset to be exchanged on a specific date or time at a specified price. The exercising of a futures contract is an obligation and not a right. The standardized nature of futures contracts allows them to be exchange traded on a financial exchange called the ‘futures exchange market’.

Futures contracts operate through clearing houses that guarantee the transaction will take place, and therefore ensures that the buyer of the contract will not default. Settlement of a futures contract occurs daily, where the changes in price are settled on a daily basis until the contract expires (called marked-to-market).

Futures contracts are usually used for speculation purposes, where a speculator bets on the movement of the price of the asset, and make profit depending on the accuracy of their judgment.

What is the difference between Futures and Options Contracts?

The major difference between these two contracts is that the options contract gives the trader an option as to whether he wants to use it, whereas the futures contract is an obligation that does not give the trader a choice.

A futures contract does not entail an additional cost, whereas an options contract requires the payment of an extra cost called the premium. If the options contract is not exercised, the only loss will be the cost of the premium.

Summary:

Futures vs Options

  • Options and futures both are derivative contracts that allow the trader to trade the underlying asset and obtain benefits from changes in prices of the value of the underlying asset
  • An Options contract is a contract that is sold by the option writer to the option holder. The contract provides the trader with the right and not the obligation to buy or sell an underlying asset for a set price during a specified period of time
  • Futures contracts are standardized contracts that list out a specific asset to be exchanged on a specific date or time at a specified price. The exercising of a futures contract is an obligation and not a right
  • The major difference between these two contracts is that the options contract gives the trader an option as to whether he wants to use it, whereas the futures contract is an obligation that does not give the trader a choice.

Futures vs. Options

The biggest difference between options and futures is that futures contracts require that the transaction specified by the contract must take place on the date specified. Options, on the other hand, give the buyer of the contract the right — but not the obligation — to execute the transaction.

Both options and futures contracts are standardized agreements that are traded on an exchange such as the NYSE or NASDAQ or the BSE or NSE. Options can be exercised at any time before they expire while a futures contract only allows the trading of the underlying asset on the date specified in the contract.

There is daily settlement for both options and futures, and a margin account with a broker is required to trade options or futures. Investors use these financial instruments to hedge their risk or to speculate (their price can be highly volatile). The underlying assets for both futures and options contracts can be stocks, bonds, currencies or commodities.

Comparison chart

Futures versus Options comparison chart
Futures Options
Transaction mandatory Yes; the buyer and seller are both obligated to complete the transaction on the specified date at the price set in the contract. No; the buyer has the option but not the obligation to complete the transaction. The seller is obliged to transact if the buyer of the option chooses. The price at which the transaction will occur is set in the option contract.
Transaction date The date specified in the contract Any time before the expiry date specified in the contract
Standardized contract? Yes Yes
Traded on exchanges? Yes Yes
Daily settlement? Yes Yes
Margin account required? Yes Yes

Contents: Futures vs Options

What are Futures?

Futures contracts are agreements to trade an underlying asset at a future date at a pre-determined price. Both the buyer and the seller are obligated to transact on that date. Futures are standardized contracts traded on an exchange where they can be bought and sold by investors.

What are Options?

Options are standardized contracts that allow investors to trade an underlying asset at a specified price before a certain date (the expiry date for the options). There are two types of options: call and put options. Call options give the buyer a right (but not the obligation) to buy the underlying asset at a pre-determined price before the expiry date, while a put option gives the option-buyer the right to sell the security.

Options are Optional, Futures are Not

One of the key differences between options and futures is that options are exactly that, optional. The option contract itself may be bought and sold on the exchange but the buyer of the option is never obligated to exercise the option. The seller of an option, on the other hand, is obligated to complete the transaction if the buyer chooses to exercise at any time before the expiry date for the options.

Why Are Options and Futures Used?

Many businesses use options and futures to hedge their risks, such as exchange rate risk or commodity price risk, to help plan for their fixed costs on items that frequently change in value. For example, importers may protect themselves from the risk of their home currency falling in value by buying currency futures that give them more certainty in their business operations and planning. Similarly airlines may use options and futures in the commodities market because their business depends heavily on the price of oil. Southwest Airlines famously reaped the rewards of their hedging strategy for oil prices in 2008 when the price of a barrel of oil reached over $125 because they had purchased futures contracts to buy oil at $52.

Prices for options and futures contracts are highly volatile — much more so than the price of the underlying asset. So investors may also use them for speculating. Brokers require margin accounts before they allow their clients to trade options or futures; often they also require clients to be sophisticated investors before they enable such accounts because volatility and risks with options and futures trading are significantly higher compared with trading the underlying asset e.g. stocks or bonds.

Options can be used to reserve the right to purchase or sell an item at a predetermined price during a set time period. For instance, a real estate investor might hold an option to purchase a piece of property during a time period while they determine if they can get the funding and permits they need. Such options, although not exchange-traded, give the buyer the “right of first refusal” when someone makes an offer on a property.

Important Options and Futures Terminology

For both options and futures, there are certain terms that are important to know. In the world of options, the terms “put” and “call” are key to the business. A “put” is the ability to sell a certain asset at a given price. A “call” is the ability to purchase an item at a pre-negotiated price. The price itself is called a “strike price” or an “exercise price.” In addition, options usually come with an “expiration date.” This date is the date by which the option would need to be put into action, otherwise the option will become null and void.

Futures have their own terminology as well. The “exercise price” or “futures price” is the price of the item that will be paid in the future. Buying an item in the future means that the purchaser has gone “long.” The person selling the futures contract is called “short.”

What can be Optioned?

There are many items that can be optioned. Options can be exercised on a wide variety of stocks, bonds, real estate, businesses, currency and even commodities. Frequently used in the investment world, options can also be used by privately held companies and individuals as a way to hold the right to purchase or sell something of value. Options do not guarantee a sale; they only provide the right to it.

What assets can be covered under a Futures contract?

Futures cover a myriad of items. Futures can be traded for currency, stocks, interest rates and other financial vehicles as well as commodities such as crude oil, grain and livestock. Unlike options, a futures contract is binding and the contract must be fulfilled per the terms of the agreement.

Popularity in the financial industry

Futures and options are a significant part of the financial trading industry and are roughly equally popular, with options having a slight advantage in volume. According to FuturesIndustry.org, during the first half of 2020, 5.46 million futures contracts and 5.66 million options contracts were traded. [1]

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What’s the Difference between Stocks and Options?

Just like stocks and futures contracts, options are securities that are subject to binding agreements. The key is that options give you the right to buy or sell an underlying security or asset, without being obligated to do so, as long as you follow the rules of the options contract.

The key differences between options and stocks are

Options are derivatives. A derivative is a financial instrument that gets its value not from its own intrinsic value but rather from the value of the underlying security and time. Options on the stock of IBM, for example, are directly influenced by the price of IBM stock.

Options, like futures contracts, have expiration dates, while stocks do not. In other words, while you can hold the stock of an active company for years, an option will expire, worthless, at some point in the future. Options trade during the trading hours of the underlying asset.

Owning an option doesn’t give the holder any share of the underlying security. The right to buy or sell that security is what options are all about.

The Basics of Futures Options

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Futures options can be a low-risk way to approach the futures markets. Many new traders start by trading futures options instead of straight futures contracts. There is less risk and volatility when buying options compared with futures contracts. Many professional traders only trade options. Before you can trade futures options, it is important to understand the basics.

Futures Options

An option is the right, not the obligation, to buy or sell a futures contract at a designated strike price for a particular time. Buying options allow one to take a long or short position and speculate on if the price of a futures contract will go higher or lower. There are two main types of options: calls and puts.

The purchase of a call option is a long position, a bet that the underlying futures price will move higher. For example, if one expects corn futures to move higher, they might buy a corn call option. The purchase of a put option is a short position, a bet that the underlying futures price will move lower. For example, if one expects soybean futures to move lower, they might buy a soybean put option.

Types of Options

There are three types of options: in-the-money (an option that has intrinsic value), out-of-the-money (an option with no intrinsic value), and at-the-money (an option with no intrinsic value where the price of the underlying asset is exactly equal to the strike price of the option).

Key Terms

Premium: The price the buyer pays and seller receives for an option is the premium. Options are price insurance. The lower the odds of an option moving to the strike price, the less expensive on an absolute basis and the higher the odds of an option moving to the strike price, the more expensive these derivative instruments become.

Contract Months (Time): All options have an expiration date; they only are valid for a particular time. Options are wasting assets; they do not last forever. For example, a December corn call expires in late November. As assets with a limited time horizon, attention must be accorded to option positions. The longer the duration of an option, the more expensive it will be. The term portion of an option’s premium is its time value.

Strike Price: This is the price at which you could buy or sell the underlying futures contract. The strike price is the insurance price. Think of it this way: The difference between a current market price and the strike price is similar to the deductible in other forms of insurance. As an example, a December $3.50 corn call allows you to buy a December futures contract at $3.50 anytime before the option expires. Most traders do not convert options to futures positions; they close the option position before expiration.

Buying an Option

If one expects the price of gold futures to move higher over the next 3 to 6 months, they would likely purchase a call option.

Purchase, 1 December $1,400 gold call at $15:

  • 1: number of option contracts bought (represents 1 gold futures contract of 100 ounces)
  • December: Month of option contract
  • $1,400:strike price
  • Gold: underlying futures contract
  • Call: type of option
  • $15: premium ($1,500 is the price to buy this option or, 100 ounces of gold x $15 = $1,500)

Buying an option is the equivalent of buying insurance that the price of an asset will appreciate. Buying a put option is the equivalent of buying insurance that the price of an asset will depreciate. Buyers of options are purchasers of insurance.

When you buy an option, the risk is limited to the premium that you pay. Selling an option is the equivalent of acting as the insurance company. When you sell an option, all you can earn is the premium that you initially receive. The potential for losses is unlimited. The best hedge for an option is another option on the same asset as options act similarly over time.

The Importance of Volatility

The chief determinate of option premiums is “implied volatility,” or the market’s perception of the future variance of the underlying asset. Historical volatility, on the other hand, is the actual historical variance of the underlying asset in the past.

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