By Aniket Bose. Edited by Arjun Chandrasekar.
Futures and options trading are among the most common and beneficial types of investing for full-time investors. Both are classified, constricted, and contracted agreements to buy and sell assets at predetermined prices. But there are some key differences, so let’s look at them right now!
Futures trading involves derivative financial contracts that restrict parties from transacting an asset at a predetermined future date and price point. The buyer in futures trading is obligated to purchase the contract or the seller has to sell the contract at an underlying asset at the set price, regardless of the current market price at the expiration date for the contract. These underlying assets usually include physical commodities and other financial instruments like stocks, bonds, and mutual funds. The futures contracts of these underlying assets detail the total quantity of them and they are also standardized to promote trading on a futures exchange.
Futures trading is a method for investors to hedge the price movement of the underlying assets so that it helps in preventing losses from price changes that are unfavorable for investors. Companies can hedge the prices of their raw materials, or products that they sell, to protect themselves from unfavorable price movements. Futures contracts may also only require to deposit a fraction of the contract if they are working with a broker.
In futures trading, it is important to identify an expiration month. For example, a February silver futures contract expires in February. Traders and investors commonly use the term “futures” to refer to the overall asset class. There are many types of futures contracts that are available for trading: commodity futures such as corn and crude oil, stock index futures such as the S&P 500 Index, currency features including pounds and euros, precious metal futures like gold and silver, and U.S. treasury futures for bonds and other products. There are quite a few cons to futures trading as well; investors run the risk of losing more than the initial margin amount since the seller issuing the futures contracts has more leverage over potential investors and buyers. Investing in futures contracts may potentially cause companies that hedged, to miss out on favorable price shifts. Margins are referred to as “double-edged swords”, which essentially means that gains are amplified but so are losses.
Options trading is a type of derivative security investment. If you buy an options contract, it grants you the authority over the investment; however, it does not obligate you to buy or sell an underlying asset at a set price on or before the expiration date. There are two common types of options trading: a “call option” and a “put option”. A “call option” gives the holder of the contract the right to buy a stock as an underlying asset under the options contract. A “put option” gives the holder of the contract the right to sell a stock as an underlying asset under the options contract. Options trading has proven to be less risky when compared to futures trading and stocks, mainly because investors require less financial commitment than equities. It is the most dependable form of hedging and this makes it much safer to invest in comparison to stocks and futures. The cons of options trading are that if you are buying “puts” and “calls”, your profit percentage is going to be relatively close to 50%, which is considerably less than investing in stocks for the long term. Traders commonly lose their money because they tend to hold on to their options too close to the expiration date. In turn, it is best to sell when you are getting a good offer at a good price, as it is much better to make some profit rather than nothing at all, even if you have to sell early.
Overall, although both futures and options are types of contracts and derivatives, their applications are vastly different. Futures basically legally obligate investors to either buy or sell, no middle ground. Options, however, grant investors the right to buy or sell, with an in-between of leaving the contract legally.
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