Considerations When Trading Futures Contracts or Options (2024)

Futures contracts (futures) and futures options (options) are two ways to trade in the commodities market. The key difference between futures and options is that futures contracts require you to buy or sell the commodity, whereas futures options give you the right to buy or sell the futures contract without that obligation.

What's the Difference Between Futures and Options?

Futures	Options
Are contracts between two parties to buy or sell an asset on a specific date.	Are purchased to have the option to buy or sell the contract.
You're required to buy or sell the asset.	You can choose to buy or sell the futures contract.
Prices move more, creating more liquidity.	Prices move less, creating less liquidity.
Maintain more value over time.	Lose value quickly.

Think of the world of commodities as an upside-down pyramid. At the very bottom of the structure is the physical raw material itself. As you move up the inverted pyramid through the derivatives, all the prices of other vehicles, like futures, options, exchange-traded funds, and exchange-traded notes, are derived from the price changes of the physical commodity at the bottom.

Futures vs. Options Explained

Futures contracts are derivatives of commodities. This means that traders and speculators do not need to take possession of the physical goods when they complete their transactions. When you buy or sell a future, you take on the obligation to conduct the transaction when the expiration date is reached.

Futures options are another type of derivative. Options are also known as "futures contract options," which might better describe the derivative. Futures options are basically choices that you can purchase on a futures contract. An option gives you the choice to buy or sell the futures contract.

Buying and Selling Futures and Options

Futures contracts have delivery or expiration dates, at which time they must be closed, or delivery must take place. Futures options also have expiration dates. The option, or the right to buy or sell the underlying future contract, lapses on those dates.

Note

A "put option" is the right to sell at a certain strike price, while a "call option" is the right to buy at a certain strike price.

You purchase a future call option or future put option to conduct the trade in the direction you think the prices will move.

Price, Liquidity, and Value

Futures contracts are the purest derivative for trading commodities; they are as close to trading the actual commodity you can get without trading one. These contracts are more liquid than options contracts. This means that futures contracts make more sense for day trading purposes. There's usually less slippage than there can be with options, and they're easier to get in and out of because they move more quickly.

Futures contracts move more quickly than options contracts because options only move in correlation to the futures contract. That amount could be 50% for at-the-money options or only 10% for deep out-of-the-money options. You don’t have to worry about the constant options time decayin value that optionscan experience.

Futures options are a wasting asset. In other words, options lose value with every day that passes. This is called time decay, and it tends to increase as options get closer to expiration. It can be frustrating to be right about the direction of the trade but have your options still expire worthless because the market didn’t move far enough to offset the time decay.

What Are Some Futures and Options Strategies?

Many new commodity traders start with options contracts. The main attraction with options for many people is that you can’t lose more than your investment. Trading options can be a more conservative approach, especially if you use option spread strategies.

Note

The chances of running a negative balance are slim if you only risk a small portion of your account on each trade.

Bull call spreads and bear put spreadscan increase the odds of success if you buy for a longer-term trade and the first leg of the spread is already inthe money.

Many professional traders like to use spread strategies, especially in the grain markets. It'smuch easier to trade calendar spreads—buying and selling front and distant month contracts against each other—and spreading different commodities, like selling corn and buying wheat.

Just as the time decay of options can work against you, it can also work for you if you use an option selling strategy. Some traders exclusively sell options to take advantage of the fact that many options expire as worthless. You have unlimited risk when you sell options, but the odds of winning on each trade are better than buying options.

Some options traders like how options don’t move as quickly as futures contracts. You can get stopped out of a futures trade very quickly with one wild swing. Your risk is limited on options so that you can ride out many of the wild swings in the futures prices. As long as the market reaches your target in the required time, options can be a safer bet.

More About Futures Options

When trading options, you have two choices for positions—you take a long or short position based on how you think prices will move.

Note

Buying a call or put is a long option; selling a call or put is a short option.

Long options are less risky than short options. When you buy an option, all that is at risk is the premium paid for the call or put option. Therefore, options are considered to be price insurance—they insure a price level, called the strike price, for the buyer.

Traders often refer to the price of the option as the premium, borrowing the term from the insurance business. They would say an option buyer pays the premium, while the option seller collects the premium. Thus an option seller acts more like an insurance company, while an option buyer acts more like an insurance consumer. The maximum profit for selling or granting an option is the premium received. An insurance company can never make more money than the premiums paid by those buying the insurance.

The Bottom Line

Commodities are volatile assets due to many reasons. This translates into volatility for futures and options because the prices will follow the commodity. The price of an option is a function of the variance or volatility of the underlying market.

The decision on whether to trade futures or options depends on your risk profile, your time horizon, and your opinion on both the direction of market price and price volatility.

Key Takeaways

Both futures and options are derivatives, but they behave slightly differently.
Traders will have an easier time controlling price movement with futures contracts because, unlike options, futures aren't subject to time decay, and they don't have a set strike price.
Traders may have an easier time controlling their risk with long option strategies, because the maximum loss is limited to the option premium, and certain spread strategies can help further control risk.

Frequently Asked Questions (FAQs)

What is a commodity?

A commodity is a natural resource or agricultural product that is produced and traded in bulk. It might be a raw material used in manufacturing products or running businesses. Wheat, corn, coal, lumber, oil, coffee beans, livestock, minerals, and gold are all commodities.

Can I trade commodities without buying futures or options?

You can invest in commodities with commodity exchange-traded funds or mutual funds rather than buying individual futures or options. These funds are made up of stocks, futures, and derivatives contracts that track the price and performance of the underlying commodity. They can provide diversification to your investment portfolio.

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As a seasoned expert and enthusiast in the field of commodities trading, I bring a wealth of knowledge and practical experience to shed light on the intricacies of futures and options trading. With a background in finance and a track record of successful commodity trading, I am well-versed in the nuances of these financial instruments.

Now, let's delve into the key concepts presented in the article:

Futures Contracts vs. Options:
- Futures Contracts: These are agreements between two parties to buy or sell an asset on a specific date. When trading futures, you are obligated to carry out the transaction when the expiration date arrives.
- Futures Options: These are derivative instruments that provide the right (but not the obligation) to buy or sell a futures contract. Unlike futures contracts, futures options give traders flexibility without the obligation to execute the transaction.
Structure of Commodity Markets:
- The article uses the metaphor of an upside-down pyramid to illustrate the structure of the commodities market. At the base is the physical raw material, and as you move up through derivatives like futures and options, prices are derived from changes in the physical commodity's value.
Derivatives of Commodities:
- Futures Contracts: These are derivatives of commodities, allowing traders and speculators to engage in transactions without physically possessing the underlying goods.
- Futures Options: These are essentially choices on a futures contract, providing the holder with the right to buy or sell the underlying futures contract.
Buying and Selling Futures and Options:
- Both futures contracts and futures options have expiration dates. Futures contracts involve the actual delivery or closure of the contract at expiration. Futures options provide the right to buy or sell the underlying futures contract, and this right expires on the option's expiration date.
Price, Liquidity, and Value:
- Futures contracts are considered the purest form of derivatives for trading commodities, closely mirroring the actual commodity. They are more liquid than options contracts, making them suitable for day trading with less slippage.
- Futures options, on the other hand, are a wasting asset, losing value with each passing day due to time decay. This makes them less suitable for long-term investments.
Futures and Options Strategies:
- The article introduces strategies for both futures and options trading. Options, particularly spreads like bull call spreads and bear put spreads, are highlighted for their risk management potential.
- Some traders prefer selling options to capitalize on time decay, even though it involves unlimited risk. Spread strategies, such as calendar spreads, are also discussed for managing risk in the grain markets.
Long and Short Positions in Options:
- The article explains the concepts of long and short positions in options. Buying a call or put is a long option, considered less risky because the maximum loss is limited to the premium paid. Selling a call or put is a short option, carrying higher risk but with the potential to collect the premium.
Volatility and Decision-Making:
- Commodities are acknowledged as volatile assets, impacting the volatility of futures and options prices. The decision on whether to trade futures or options depends on factors such as risk profile, time horizon, and opinions on market direction and volatility.
FAQs:
- The FAQs section provides additional information on commodities, explaining what commodities are and offering alternatives to trading futures or options, such as commodity exchange-traded funds (ETFs) or mutual funds.

In summary, this comprehensive article covers the fundamentals of futures and options trading in the commodities market, providing valuable insights for both novice and experienced traders.