Knowing the Difference: Options Contracts vs Futures Contracts
One of the first decisions a beginner trader has to make when trading commodities are whether to trade futures or options contracts. Even the most experienced traders go back and forth when deciding which to use. It all depends on understanding their differences, your trading style and trading plan.
Both futures and options contracts have their pros and cons and depending on the situation they are used together by some traders. Other traders prefer to focus on just one of the two, but to make the best choice you must first fully understand each of their attributes.
Options contracts allow investors the right to buy or sell a security at a pre-decided price. The buy or sell action must be executed on or before the expiration day of the contract. Futures contracts are agreements that bind buyers to purchase a specific asset and sellers to sell and deliver an asset at a predetermined price on a set day in the future.
The significant difference between options and futures are in the responsibility they put on their buyers and sellers. An options contract gives the buyer the right but does not obligate the investor, to buy (or sell) a particular asset at a specific price at any time during the viability of the contract. The option seller has to comply with whatever action the option buyer decides to take. While with futures contracts the buyer and seller must satisfy the contract regardless of price moves.
An investor can enter into a futures contract with no upfront cost, this is apart from the commission amount, whereas buying an options position requires the payment of a premium. The premium is the maximum amount the purchaser of the contract can lose. The price of the premium can increase and decrease to allow investors to sell their contracts before the expiration date. As the date of expiration gets closer the value of the options contract devalues. For future contracts, devaluation isn’t an issue because the contract’s execution is definite.
Another critical difference between options and futures is the price of the financial instrument that the contract is based on. Usually, the underlying position is much more significant for futures contracts, that in combination with the obligations to execute the agreement increases the risk of futures contracts. Options contracts, on the other hand, offer limited risk due to their premiums.
When it comes to expiration futures and options contracts, work differently. With the futures contract, the expiration date is fixed, whereas options contracts can be executed before the expiration date or on it. For many traders, the surety that the deal will be completed at a specific time makes futures contracts appealing.
Once you’ve considered the differences of these derivatives the decision on which one to trade comes down to the amount of risk you’re willing to take and your analyses of market movement. No matter which contract you decide to use, ensure that you have a proper trading plan ready for execution.