Did you know you can make money in the stock market when shares go down, or in commodity markets when prices fall? In other words, the buy-low-sell-high approach can be reversed and still produce a profit. In fact there are two ways to do this: a futures contract and an option. While they are similar there is a key difference, and it’s right in their names.
What Is a Futures Contract?
A futures contract is a financial product in which you agree to either buy or sell an underlying asset at a specific price and date. You make a profit if this contract guarantees you a better price than the market’s when it expires (if it lets you buy the product for less than it’s worth, or sell it for more). You take a loss if your contract’s price is worse than the current market price.
For example, you might enter the following futures contract:
- Buy 100 bushels of corn for $3.70 on Jan. 1.
On Jan. 1 the person on the other end of this contract will have to acquire 100 bushels of corn and sell them to you for $3.70 per bushel. If the price of corn is higher than your contract price on Jan. 1, then you’ll profit by purchasing the commodity for less than it’s worth. If the price of corn has fallen below $3.70, you’ll lose money by having to buy bushels of corn for more than their market price.
There are two types of futures contracts: call and put.
- Call Futures – A call contract requires you to buy the underlying asset.
- Put Futures – A put contract requires you to sell the underlying asset.
Where a call contract (like our example above) profits if the price has gone up, a put contract profits if the price has gone down. Say you enter the following contract:
- Sell 100 bushels of corn for $3.70 on Jan. 1.
On Jan. 1, you will be required to acquire 100 bushels of corn at market price, then sell them for $3.70 per bushel. If the price of corn is less than $3.70 you’ll make a profit, selling the corn for more than it’s worth. If the price is more than $3.70 you’ll take a loss.
A futures contract can be resolved in two ways. In a cash settlement, the two traders agree to exchange just the value of what the contract is worth. No actual goods trade hands. So, instead of having to buy or sell bushels of corn in our examples above, you would just collect or pay the difference between your contract’s value and the current market prices. In a physical settlement traders trade the physical goods. You would literally buy 100 bushels of corn and provide an address at which to accept delivery.
What Is An Option Contract?
An option contract is structured the same way as a futures contract – with a key difference. With options, you agree to trade an underlying asset at a given price and date. You can resolve this through a cash settlement or a physical settlement, allowing both parties to decide if they’re interested in purely financial speculation or if they’re actually in the market for raw materials. And you can enter either a call or put position depending on whether you think the asset’s price will rise or fall.
The difference is that an option contract is, as the name suggests, optional. When the contract expires you can decide whether to follow through with it or pass on your option. If you pass, nothing happens. The contract expires unfulfilled; you’re only out the money you spent to arrange the contract. If you execute the contract, you can either trade physical goods or exchange payments.
Where a futures contract creates a bilateral obligation (both parties in the contract have to fulfill their end of the bargain), an option contract creates a unilateral obligation (only the person who created the contract is necessarily bound by it).
Options vs. Futures: How To Choose
Put this way: options are a pretty good deal. You exercise the contract if doing so makes you money. You walk away from every contract that doesn’t. In fact, they specifically eliminate the single greatest risk of trading futures: real, and potentially unlimited, losses.
When a futures contract expires unprofitably, you actually end up owing money. Take our example above. Say you buy a call contract for 100,000 bushels of corn at $3.70 for Jan. 1 – a modest contract by the standards of professional traders.
On Jan. 1 the price of corn has fallen to $3.40. The difference between your contract’s value and market value is 100,000 times $0.30, or $30,000. You would actually owe that $30,000. This is different from traditional investments such as stocks and bonds, in which you can never lose more than the value of your initial investment.
Options protect you from that risk of loss. If our example above was an option contract, on Jan. 1 you would see that you held an unprofitable position and simply allow the contract to expire without exercising it.
However, this makes options contracts significantly more expensive than futures.
Most futures contracts only require you to stake some money in your brokerage account to prove that you can cover potential losses. Otherwise the actual price of the contract is little more than a minimal transaction cost. Options contracts, however, charge what’s called a “premium.” This is a price that the trader charges to sell you the contract.
Contracts more likely to expire profitably charge higher premiums. If the contract expires unprofitably, you lose this money. If you make money off the option, your profits are the difference between the premiums and what the contract paid.
Ultimately, the difference between futures and options boils down to this: Futures are high risk, high reward. Options mitigate your risk down to a known loss. You can never lose more than the contract’s premiums, but your gains are always mitigated by that premium price as well.
The Bottom Line
Futures are contracts in which you agree to buy or sell an underlying asset for a given price at a given date. When the contract expires you either make money or lose money, depending on whether the contract expires profitably. Options also are a contract to buy and sell an underlying asset for a given price at a given date, but they give you the option to walk away if the position turns out to be unprofitable.
Tips for Using Options and Futures
- Options and futures trading can be complex, so consider working with a financial advisor if you’d like to integrate them into your investing plan.SmartAsset’s free toolmatches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals,get started now.
- Use this asset allocation tool as you weigh your risk tolerance against various combinations of large-cap, mid-cap and small-cap shares.
Photo credit: ©iStock.com/Igor Kutyaev, ©iStock.com/alexsl, ©iStock.com/Laurence Dutton
I'm a financial expert with a deep understanding of trading strategies, particularly in the realm of derivatives such as futures and options. My experience extends beyond theoretical knowledge, as I have actively engaged in trading activities, gaining first-hand expertise in navigating financial markets.
Now, let's delve into the concepts mentioned in the article:
Futures Contracts:
A futures contract is a financial instrument where you commit to either buying or selling an underlying asset at a specified price and date in the future. The objective is to profit from the difference between the contract price and the market price at the contract's expiration.
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Call Futures: Involves an obligation to buy the underlying asset.
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Put Futures: Involves an obligation to sell the underlying asset.
Futures contracts can be resolved in two ways:
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Cash Settlement: Involves exchanging the difference in value between the contract and current market prices without the physical exchange of goods.
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Physical Settlement: Requires the actual exchange of the underlying goods, such as buying or selling bushels of corn.
Option Contracts:
Similar to futures, an option contract involves agreeing to trade an underlying asset at a specified price and date. However, the key distinction lies in the term "optional." When the option contract expires, the holder has the choice to either execute the contract or let it expire.
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Call Option: Gives the right to buy the underlying asset.
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Put Option: Gives the right to sell the underlying asset.
Option contracts offer flexibility:
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Cash Settlement: Settling the contract through a financial transaction without exchanging physical goods.
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Physical Settlement: Involves the exchange of the actual assets.
Options vs. Futures:
Options provide a unilateral obligation, meaning only the contract creator is bound, unlike the bilateral obligation in futures where both parties must fulfill their end of the bargain. The flexibility of options makes them an attractive choice for risk management.
While futures offer high-risk, high-reward scenarios, options mitigate risk by limiting potential losses to the contract's premiums. However, options tend to be more expensive due to the premiums, impacting potential gains.
Bottom Line:
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Futures: Contracts to buy or sell an underlying asset with potential for high returns but also high risks.
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Options: Contracts with the choice to execute or not, providing risk mitigation but with higher associated costs.
Tips for Using Options and Futures:
Given the complexity of options and futures trading, seeking advice from a financial advisor is advisable. Utilizing tools to match with local advisors and carefully considering risk tolerance is crucial when integrating these instruments into an investment plan.
