In the financial market, most financial trades or contracts can be executed as futures or as options contracts. Many beginner traders do not know the difference. For instance, it was recently in the news that Bakkt, a company backed by the Intercontinental Exchange (ICE), was going to list its options contracts on Bitcoin on the 9th of December in Singapore. The same company had in September, launched its futures contracts on Bitcoin. So here we have a company that is set to offer trading of Bitcoin as futures and options contracts. So what is the difference here, and indeed, what similarities exist between both types of contracts? This is what this article seeks to explain. So here we go.
The similarities between options and futures are spelt out below.
The first similarity is obvious: they are financial market derivative contracts. What is a derivative? A financial market derivative is defined by the Oxford dictionary as a product (such as a future, option, or warrant) whose value derives from, and is dependent on the value of an underlying asset, such as a commodity, currency, or security.
Therefore, it can be seen that both futures and options contracts are similar in this respect. Futures and options contracts have no life of their own and have to be based on an underlying asset such as a stock, commodity, currency and lately, cryptocurrencies.
Most futures and options contracts must have two parties to the trade. These are the dealer and the trader, or the buyer and seller. At different times, the trader may buy an asset from the dealer, or the seller may sell the asset to the dealer. But at all times, there must be two parties to the futures/options trades.
Futures and options contracts are leveraged. This means that the trader is able to hold buy or sell a contract that is worth more than the original capital, by just putting up a small measured amount as collateral while the broker provides the rest. Futures and options contracts cost a lot to setup, so it is necessary that traders are leveraged to make them more available.
Futures and options contracts are usually traded on exchanges. This allows for the standardization of contracts, which provides a level playing field for participants and ensures transparency in pricing.
Futures and options contracts can both be used for speculation and for hedging. For instance, if you do not want to trade an underlying security directly, you may decide to use futures and options on such an asset as a way of protecting yourself from direct exposure to that market.
These are some of the similarities between futures and options. Now let us go over the differences.
What are the differences between options and futures? Some of these are listed below.
Look at the definition of futures and options contracts. In a futures contract, it is obligatory on both parties to conclude the transaction at the agreed price, on an agreed date. There must be delivery of the product by the seller, and payment by the buyer on the agreed date, at the agreed fee. In contrast, options contract does not place an obligation to the options buyer to fulfil the transaction. So the buyer of the options contract may decide not to exercise the option, allowing it to expire. In the same vein, the seller of the contract is only mandated to carry through with the transaction if the options buyer chooses to exercise the option. This is the major difference between futures and options contracts.
When it comes to the settlement dates of the contracts, futures contracts are designed in such a way that the contracts are settled only on the date specified when the contract or trade was being initiated. In contrast, options contracts can be exercised before the expiry/settlement date, which creates a major source of difference between futures and options contracts.
There are only two trade possibilities for futures contracts: buying and selling. However, options contracts come with more than two trade possibilities. The options trader can use the naked calls and puts (equivalent to buy/sell trades), or can use other varieties of trades such as spreads, straddles, strangles, condors, etc. So technically speaking, options trades are more complicated to setup than futures trades.
By extension from point (4), it is safe to say that while profits on futures contracts are made strictly from the direction of the trade in relation to the entry price, some options trade types do not necessarily depend on direction for the trade to be profitable. For instance, if a futures trader sells 100 units of a futures contract at $10, the trader will need the price to drop in order to make profit. In contrast, an options trader who decides to purchase a credit spread option, will have to set up both a buy and a sell on the same option, at different prices. For this credit spread to become profitably, the trader will need the spread to either remain static or to narrow and expire in that condition. So for options trades, profitability is much more than just direction.
Futures contracts are predominantly used for trades where delivery of the underlying product is required. For instance, if a seller agrees to sell 100 bushels of corn to a buyer at an agreed price, for delivery and settlement on a future date, the transaction settlement will involve actual physical delivery of the corn in question, in exchange for the physical cash as well. For options contracts, this is not the case. Physical delivery of the underlying asset as part of the settlement is not usually required.
Futures contracts are usually bigger-level trades and therefore require larger margin collateral to setup the trades than options contracts. That is why it is more common to see institutional traders than retail traders in the futures market.
These are the commonest similarities and differences between futures and options contracts. After reading this article, you should now be able to distinguish between a futures contract and an options contract.