Futures vs Options
What Is a Futures Contract?
A futures contract is an agreement between two parties to exchange a specific asset at a predetermined price on a specific date in the future. The buyer of the futures contract agrees to purchase the asset from the seller at the agreed-upon price. The seller agrees to sell the asset to the buyer at the agreed-upon price.
Who Trades Futures?
Futures contracts are traded by professional traders and investors, as well as individual investors. Mostly, they are traded by institutional investors. Institutional investors refer to a group of investors who have a large amount of capital that they want to invest. They use futures contracts as a way to manage their funds, or as part of asset management strategies.
Example of Futures Contract
An institutional investor may buy a futures contract on wheat. The price of the wheat will be set at the time the contract is bought, and the contract will expire at a specific date in the future. The investor will then need to find someone to sell the contract to if they want to exit their position before the expiration date. An example would be:
- A futures contract to buy 100 bushels of wheat for $5 on April 1, 2022.
This means that the person on the other end of the contract has to buy 100 bushels of wheat and sell them at $5 per bushel. If the price of wheat goes higher than your set price at $5, this would entail a profit because you have purchased the bushel of wheat for less than its price. But, if the price of wheat hits lower than the price you have set at $5, this would be a loss on your part because you have to pay the agreed price at $5 which is higher than the market price.
What Is an Options Contract?
An options contract is a type of derivative security. A derivative security is a financial instrument whose value is based on an underlying asset. Options contracts give the holder the right, but not the obligation, to purchase or sell an underlying asset at a predetermined price on or before a specific date in the future.
Types of Options
There are two types of options: call options and put options.
A call option is a type of options contract that gives the holder the right to purchase an underlying asset at a predetermined price on or before a specific date in the future. The holder of a call option has the right, but not the obligation, to purchase the underlying asset at the specified price on or before the expiration date.
A put option is a type of options contract that gives the holder the right to sell an underlying asset at a predetermined price on or before a specific date in the future. The holder of a put option has the right, but not the obligation, to sell the underlying asset at the specified price on or before the expiration date.
Example of Options Contract
An options contract requires that the holder of the options contract buy or sell an underlying asset by a specific date in the future. For example, on April 1, 2022, you may purchase an $8 call option with 100 bushels of wheat as the underlying asset. This means that you have the right to buy 100 bushels of wheat for $8 each at any time before April 1, 2022 without obligation. However, if you choose not to exercise your option and do nothing, it will expire worthless and this would entail a loss on your part because you’ve paid some money for this.
Futures vs Options: Which Is Better?
There is no definitive answer when it comes to whether futures contracts or options contracts are better in trading. Both have their advantages and disadvantages, which depend on the individual trader’s needs and goals. Futures contracts are more commonly used by institutional investors, while options contracts are more popular with retail traders. Futures contracts are typically more liquid than options contracts. This means that they can be easier to trade, as there is a larger pool of buyers and sellers. However, options contracts offer greater flexibility, as they give the holder the right to purchase or sell the underlying asset at the specified price.
The Bottom Line
There is no right or wrong answer when it comes to whether futures contracts or options contracts are better in trading. Both have their advantages and disadvantages, which depend on the individual trader’s needs and goals. When deciding which type of contract to use, it is important to consider the liquidity of the market, as well as the flexibility that the contract offers.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.