Stock options and stock futures are agreements between selling and buying parties for a share of equities and are based on a deadline. Both contracts offer investors strategic opportunities to earn money while hedging current investments.
Option Contracts
As you may already know, there are put options and there are call options. A trader can either buy a put or a call option.
Call option refers to the right to purchase stocks at strike price before expiry. For example, there’s a call option to purchase stock XYZ for $50, and the option is going to expire in three months. Currently, the stock is being traded at $49. If, for instance, before or during expiry, the stock is traded at $60, which is above $50, the buyer could exercise his right to purchase the stocks at $50.
The buyer will purchase the stocks for $50 from the call writer and will sell the stocks for $60, earning a profit of $10 for every share. Otherwise, the buyer can choose to sell the call to gain profit since the call option will be worth $10 for every share. If, on the other hand, the option is traded below $50 at expiry, then it will be worthless, and the buyer will lose whatever it is that he paid for the option, which is known as the premium.
The risks that the call option buyer will have will be limited to the amount he paid for the premium. Furthermore, the cost of the premium will depend on certain factors which include how far the strike price will be from the current price of the underlying stocks and the amount of time left until expiry.
Put option refers to the right to sell the XYZ stock at a strike price on or before the expiry. The trader who will purchase the option will understandably want the price of the stocks to decrease. If you have a put that gives you the right to sell the XYZ stock for $100 and the price of the stock lowers to $80 before it expires, then you’ll end up with a $20 gain for every share, which is less than what you paid for the premium cost. If, for instance, the cost of the XYZ stock has gone to more than $100 upon expiry, the option will be worthless, and you’ll lose whatever you paid for the option. In this case, the put buyer may continue to profit until such time that the stock falls to $0.
Futures Contracts
Futures contracts refer to the obligation to sell or buy a commodity or other assets at a later date, and at an agreed cost.
Assuming two traders have agreed for a $100 price on an oil futures contract. Then the buyer is willing to purchase the oil at $100 upon expiry while the seller agreed to sell it for $100. If if the cost of the oil increased to $105, the buyer who bought the contract for $100 will be making money out of the trade since they could sell at $105, but instead, they have only agreed for $100.
This is where the major difference between retail and international traders comes in. The retail traders purchase and sell futures contracts while betting on the direction of the price of the underlying contract. They want to basically gain profit from the future contract’s change in price. They really don’t have any intention to take possession of the actual barrels of oil or deliver the oil. But some institutions will use the futures contracts for such purpose. This is why the futures have been invented. It allows companies to be able to purchase products that they need or sell the products they produce at an agreed price at future dates. This option also allows them to come up with future plans for their business and ensure proper inflow and outflow of products in the future.
Main Differences Between Futures and Options
Before the investor can make a decision to trade with either options vs futures, they have first to understand the main differences between these two.
- Contract Premiums
If the buyers of put and call options will buy a derivative, they will have to pay the one-time fee known as the premium, while the sellers of the put and call options will have to collect the payment. The contracts’ value will decay when approaching the settlement date. But the premium price could increase or decrease, which gives users the option to sell their puts and calls to gain profit ahead of the expiration. Those who choose to sell options can possibly buy call options to cover for the amount of their position.
Stock futures can be bought on SSFs or single stocks or through the broader performance of indices like S&P 500. But with stock futures, the buyer will have to pay something on top of the premium at a certain point of the purchase. The buying parties will have to pay for something called the initial margin, which is basically the percentage of the price that will be paid for the stocks.
- Financial Liabilities
If someone is going to purchase a stock option, the only liability involved will be the cost of the premium at the time when the contract is bought. But if a seller will open the put options to be bought, they will be exposed to the maximum liability of the stock’s given price. If the put option will give the buyer the right to sell the stocks for $50 per share, but the stock has fallen to $10, then whoever initiated the contract should pay for the stock at a contract’s value, which is $50.
However, future contracts provide maximum liability for both the seller and the buyer of the agreement. As the underlying price of the stocks shifts in favor or against the seller or buyer, both parties will be obliged to contribute more to their trading accounts to satisfy the daily obligations.
- Buyer and Seller Obligations
Whoever buys the put or call options will be given the right to purchase or sell the stock at a certain strike price. But they will not be obligated to exercise the option once the contract expires. Investors will only exercise contracts once they have the money. Once the option is out of money, the contract buyer will have no obligation to buy the stock.
Buyers of futures contracts will be obliged to purchase underlying stocks from the seller of such contract upon its expiration regardless of the price of the underlying asset. If, for instance, the futures contract will call for the purchase of stock for $100, but the underlying stock costs $80 at the expiration of the contract, the buyer should purchase it upon the agreed price. Nevertheless, it’s extremely rare for stock futures to be held until their expiration date.
- Investment Flexibility
Stock options offer investors both the right to purchase a stock and the right to sell such stock, but without the obligation. However, stock options offer investors a lot of flexibility, which is not available in futures trading. Each of these strategies provides varying profit potentials for both the speculators and investors.
On the other hand, stock futures provide little flexibility as soon as the contract is started. As stated, investors will buy both the right and the obligation for fulfillment as soon as the position is opened.
Options and Futures Example
Let’s take for example the futures and options contract for gold. One of the gold options contracts on CME or Chicago Mercantile Exchange possesses an underlying asset known as the COMEX gold futures contract instead of the gold itself. If an investor is looking to purchase an option, he might buy a call option at $2.60 per contract, and with the strike price of $1,600, that’s due to expire in February 2019.
The holder of such call is interested in gold and has every right to assume the position of underlying gold futures until such time that the option expires when the market closes on February 2019. If the cost of the gold will rise higher than the $1,600 strike price, the investor will have to exercise his right to acquire the futures contract or he will leave the options contract to expire. The maximum loss of the holder of the call options is at the $2.60 premium that he paid for the contract.
The investor might instead decide to acquire a futures contract on gold. A futures contract comes with an underlying asset of 100 troy oz. Gold. The buyer will be obliged to receive the gold from the seller during the delivery date, which is stated in the contract. If, for instance, the trader is not interested in the physical commodity, he always will have the option to sell the contract before delivery or roll it over to the new futures contract.
If the cost of gold goes up or down, the amount gained or lost will be marked to market in the account of the investor after the trading day ends. When the cost of gold falls below the cost of the contract that the buyer has agreed to pay, he will still be obliged to pay the higher price upon the delivery date.
Trading Options on Futures Contracts
Future contracts apply to all types of financial products, whether that’s equity indexes or precious metals like gold. Trading options that are based upon the future simply mean buying a put or call options depending in the direction that you believe the particular product is going to go.
Buying options offer a way to gain profit from the future contracts’ movement, however, only at a fraction of the overall cost of purchasing the actual future. You need to buy a call if you’re expecting for the value of the future to go up. Otherwise, buy the put if you’re expecting for the value of the future to decrease. The amount that you’ll pay for the option is known as the premium.
Options on Futures
Some futures contracts come with options that are attached to them. For instance, good options are usually based upon the cost of the gold futures (underlying) both are cleared by the CME (Chicago Mercantile Exchange). Purchasing future contracts will require paying for the initial margin of $7,150. It’s the CME that sets the amount and will vary according to the futures contract, giving control of 100 oz. of gold. Purchasing gold option for $2, for instance, will only cost $200 ($2 x 100 oz.), where $200 is the premium. The premium, as well as what the option is able to control will vary depending upon the option, however, an option position will usually cost less than its futures position.
If you think that the cost of the underlying asset is going to increase, then go ahead and buy a call option. But if the underlying asset increases right before the option has expired, then the value of your option is going to increase. If, if the value will not increase, then you’ll end up losing the money that you paid for the premium.
If you think that the underlying is going to decrease, then buy a put option. If, for instance, the underlying will go down in value right before it expires, then your option’s value will increase. However, if the underlying will not increase, then you’ll lose the money you paid for the premium.
The prices of options will usually depend upon the “Greeks” variables that affect the cost of the option. The Greeks refer to a set of risk measures which show how exposed an option will be to decay.
Options are purchased and sold before the expiration to lock a profit or to reduce the number of losses.
Writing Options for Income
If someone is going to purchase an option, someone else will have to write such an option. The writer can be anyone and will receive the premium that the buyer will pay upfront. But he will be liable to cover any of the gains that the buyer will earn from that option. The profit of the options writer will be limited on the amount of premium received. However, the liability will be large in this case since the options buyer is expecting for the option’s value to increase. As a result, the option writers will own any underlying future contracts that they write the options on. This will hedge any potential loss from writing the option while the writer will end up pocketing the premium. This process is known as “covered call writing.” This is basically the trader’s way of generating trading income from options coming from the futures that they have on their portfolio. The written option can be closed anytime to lock a certain amount of the premium or to minimize the loss.
Conclusion
The option to use stock futures, standalone options, or both will require careful assessment of the individual’s investment goals and expectations.
One of the most important questions that investors should ask is how much of a risk would they be willing to take on for their investments strategies. Options trading offers less upfront risk for buyers due to the fewer obligations needed to apply the contract. Therefore, this offers a more traditional approach, especially if the traders follow several additional strategies, such as put spreads and bull call to improve the chances of trading success in the long run. Once you understand the risks that it comes with, it’s highly recommended that you check out some of the best options brokers in the market.