Trading Options and Futures – Comparison
In trading circles, once often hears the terms options and futures used somewhat equivalently. And while it is true that investing in futures (commodity options) and stock option trading may be very similar in theory; they are, in truth, two very different animals in practice, and confusing the techniques used in both fields can be a very costly mistake to make.
The purpose of this article is to go into some detail in explaining the difference between stock option investing and commodity option investing in order to help you make the right investment choices.
How Does Stock Option Investing Work?
This is covered in detail elsewhere in the site, but in short, an option is essentially a contract which imbues the holder with the right to selling and buying shares (a specific amount) of stock in a company (also currency, or whatever is traded in the market). This contract in essence empowers its holder to exercise these rights if he of she chooses to do so. A stock options contract is valid only for a defined time period, and stocks traded can only be bought or sold at a the fixed, previously agreed price.
How Does Futures Trading Work?
Unlike a stock option contract, a future is a transferable contract that requires the delivery of a particular stock, currency or whatever commodity is traded. Like an option, the delivery of the commodity is concluded at the fixed price stated in the contract, at or before the expiry date.
The key point is that a futures contract holder is required to exercise the conditions of the contract – with options, the holder is given the liberty of deciding whether or not to exercise the option.
Options vs Futures In More Detail
Apart from this key distinction between the stock option investing patten and that of futures, there exist a number of other divergences that encompass the size of underlying stocks and shares / commodities traded, brokerage commissions, and how returns are created.
The futures investor had the ability to sign the contract without paying immediately. Conversely, an investor cannot buy an options position without the current contract holder. One can think of this as payment for the privilege avoid being required to purchase the underlying stock/commodities – a valuable privilege where there have been adverse movements in the price of the underlying stocks, etc.
Another area where stock option investing and futures investing do not mirror each other is in the magnitude of the underlying positions that can be traded. Usually, futures contracts accommodate much large underlying trades. In this way, the requirements that go along with futures make them riskier for the contract holder to trade – there may be a lot to lose.
Finally, options and futures contrast in terms of the method by which return are obtained by those involved. In the case of stock options, gains can be reaped by any of three techniques. The holder can:
- Exercise their option
- Buy an opposite option
- Hold until the expiry date of the contract comes, when they will collect the difference between the current market price and the strike price (see the article The Two Types of Stock Options), which could be a profit.
On the other hand, profits for futures investments can only be gained by either correctly predicting the market trend, additionally holding an opposition position to deal “opposite” market trends, or through day trading futures, using the short-term change in the value of the underlying positions at the end of every trading day.
Understanding the contrasts between the techniques and rules for options trading and futures trading will surely enhance your understanding of the stock market, and this can help stop you from choosing poor investment if you ever decide to give stock options investing or futures investing a go. Couple this with some experience in the two fields, with perhaps some extra exposure to how day trade investors work, and you could make substantial returns
As always, be extremely careful never to make any investment without completely discerning what you are dealing with. Doing some hard work at the beginning might save you a bundle in the future.
