Key Takeaways
- What are options?
- What are futures?
- Similarties of futures vs. options
- Key differences of futures vs. options
There are several similarities between futures and options: they are both derivative investments, they both require speculation, and they can both be highly profitable. Though perhaps the most important similarity is that both of these investments offer a great way to diversify your portfolio.
While nothing says you cannot invest in both futures and options, investors who want to choose the best place to start should look at the differences associated with these assets. When it comes to futures vs options, there are a few key factors that can help you decide which investment is right for your portfolio. Keep reading to learn more about how to decide between futures and options.
What Are Options?
Options are contracts to purchase a certain number of shares in a company (usually 100) at a predetermined price. They get their name because investors have the “option” to purchase the contracts at a specified point in the future. Investors typically pay a premium for the options, which then gives them the ability to purchase the shares at what is called a strike price. The strike price can be higher or lower than the actual value of the shares, depending on the performance of the company.
Options are a type of derivative investment, meaning their value is solely linked to the value of the asset they represent — called an underlying. In many cases the underlying is stocks, but it can also be ETFs or commodities. Investors can profit from options using a few different trading strategies but generally make money by speculating on whether stock prices will go up or down and purchasing options accordingly.
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Types Of Options
There are two different types of options depending on whether investors are buying or selling. The two option types are:
- Call Options: Call options are contracts that give investors the right to buy the underlying at a specific price. If investors speculate that the share price of a certain company is going to increase, they can buy call options to benefit from this jump.
- Put Options: Put options can be thought of as the opposite scenario. They give investors the option to sell stocks at a certain price before the expiration of the contract. Put options increase in value as the share prices of the underlying asset decrease.
Buying & Trading Options
Options are bought and sold on a market and are almost always managed with the help of a broker. Investors can earn money from buying and trading options in a few different ways. The simplest model is by predicting changes in share prices and purchasing call or put options accordingly. By doing so, investors are essentially analyzing the stock market and making bets on the performance of various companies. While this options strategy can be highly profitable, there are numerous other ways to add options to an investment portfolio.
Investors can also opt for more complex or long-term trading strategies. For example, a bull call spread allows investors to profit from a gradual increase in the price of an underlying stock. It works when investors purchase a long call with a low strike price and write a short call with a higher strike price (We will get into long and short calls below). The profits are limited to the difference between the options, but there is still potential to earn money while minimizing risk. A few other common strategies when trading options include a bear call spread, a married put, and a covered call. To learn more about each of these options trading strategies and more, be sure to read this guide.
Long vs. Short Options
The difference in long vs short options lies in who is buying and selling. Unlike call vs put options, the distinction between long and short trading refers to the investor’s actions — not the underlying shares. A long option is when an investor buys an option, making them the option holder. For example, if you believed Apple stock was going to increase you could buy a call option representing Apple shares. This would be referred to as a long option.
A short option is when investors write the options contracts for other investors to buy. In this example, let’s say you already own shares in Apple. You could then sell options representing your shares to another investor, which would be called a short option. Short options can be used to earn money in the form of premiums (which the buyer would pay to purchase the options) or as a way to minimize loss if you believed your shares might decrease in value.
Advantages Of Options
The biggest advantage of options is in the name: investors have the option to walk away from the contracts. While investors do pay a premium to acquire options contracts, the overall loss is minimized if the share prices do not rise or fall as expected. Generally speaking, options investing can be a great way to reduce risk when purchasing stocks.
Another advantage of options is that they offer a way to hedge risk against declining stock prices. For example, if you were to purchase an option against your portfolio you could potentially minimize overall losses if your owned shares were to decrease in value. This strategy, though not guaranteed, is a surprisingly common reason for investors to purchase options.
Options can also allow employees to purchase equity in their company, as stock options are an increasingly common employee benefit. Similarly, they can provide investors with the chance to purchase stocks at lower than average prices at a number of companies. This gives investors the opportunity to own shares without purchasing them outright.
Risks Of Options
With any investment type, there are risks associated with buying and trading options. One of the most common mistakes investors make when purchasing options is diving into a complex investing strategy without doing the proper research. Options require a thorough understanding of trading strategies and the stock market. It can be risky to purchase options without a good idea of how these practices work, even if you are investing with a trusted broker.
A common misconception about options is that investors must wait until right before the expiration date to strike. In reality, the expiration date of an options contract is only a deadline. By waiting until the contract is about to expire, some investors risk losing out on potential profits as stock prices continue to fluctuate. This can prevent investors from maximizing their total profits, and in some cases even lead to losses.
What Are Futures?
Futures are a form of financial contract stating that investors must buy or sell a given asset at a predetermined price. Futures must be bought or sold by the date specified in the contract. Similar to options, futures are also a derivative investment. They often represent commodities, but can also deal with securities and other financial assets. Futures allow investors to guarantee the price of a specific asset, which can be a useful tool when minimizing overall portfolio risk.
The market for futures was created to protect institutional buyers — who take ownership of a commodity before distribution. The best way to understand this practice is by looking at an example. Let’s say a wheat farmer wants to guarantee crop prices before the season starts. That farmer could purchase a futures contract to establish a set price for their wheat. This guaranteed contract will protect the farmer in case the crop prices fall, while simultaneously protecting the contract writer in case prices rise.
Buying & Trading Futures
The practice of buying and trading futures is most commonly used for investing in commodities. They are known to move quickly and are popular for day trading purposes. Like options, many futures strategies revolve around speculation. Investors who purchase futures contracts must be familiar with the commodity they are investing in so they can predict price movements.
Many investors use spread strategies when purchasing futures contacts to minimize overall risk. For example, a common futures investment strategy is to purchase contracts for different commodities. In doing so, investors can protect their portfolios from the potential rise or fall of a specific commodity, like oil for example.
Advantages Of Futures
The main advantage of futures is that they provide investors the opportunity to diversify their existing portfolios. Because futures contracts commonly represent commodities, they give investors the chance to profit from commodity prices without actually purchasing the underlying asset. This can be a great way to tap into market profits, while also minimizing the risks associated with purchasing commodities themselves.
Futures are also attractive to investors because they are a very liquid investment. Futures markets are open nearly 24 hours a day and are often traded in large numbers. The constant movement associated with futures essentially means investors can buy and sell at a faster pace when compared to other investments.
When comparing futures to other investments, such as stocks, they are thought to be a more fair way to trade. It is often much more difficult to obtain inside information when it comes to trading futures. While big corporations may be at risk of leaking important information regarding stock prices, futures do not experience this same threat. For this reason, many investors believe futures to be a more efficient way to trade.
Risks Of Futures
The biggest risk associated with futures goes hand in hand with one of its greatest advantages: the 24-hour market. Because futures markets rarely stop moving, they are highly susceptible to global events. For example, the effects of 2020 on the oil market are still yet to be fully realized. Investors who trade futures must be prepared for fast-moving markets when purchasing futures contracts, or they risk unpredictable losses.
Another risk associated with futures contracts has to do with leverage. Leverage refers to the ability to work with investments while only purchasing a portion of their total value. When trading futures contracts, investors can put up as little as 10 percent of the actual contact. If the market were to move against an investor’s prediction they could lose more than their initial investment. To prevent this from happening, it is generally advised that buyers have enough capital to back up their investments.
Futures vs. Options: Similarities
Now that we have defined futures, options, and how they both work, let’s go over a few more similarities they share:
- Margin Account Requirements: Both future trading and option trading require margin accounts. This does not exclude IRAs, however, you must establish a third-party custodian for the account. Individual brokerage accounts with margins are commonly used for retail traders. This is beneficial for keeping retirement investments separate from options and future trading.
- Insurance Uses: Futures and options alike can be used as a type of insurance to protect the downside for investment positions or keep pricing within an understood range.
Futures vs. Options: Key Differences
Futures and options can both be great additions to a well-rounded investment portfolio. While they do have several similarities, such as both being derivative investments, there are several key differences to be aware of. Here are some key differences when looking at futures vs options:
- Option To Buy: While options are known for the ability to walk away from a sale, futures are binding contracts. This means investors are required to buy or sell the underlying assets by a given point in time. This can help or harm your profit potential depending on the underlying asset of your futures or options contracts.
- Premium Payment: When trading options, investors are required to purchase the contracts upfront by paying a premium. Futures rely on leverage and require buyers to pay as little as ten percent upfront. This difference can translate to different loss potential, as futures holders may have to come up with extra capital if their investment does not perform as planned.
- Taxes: The taxes associated with futures are thought to be more advantageous when compared to options. This is due to the IRS section 1256 which caps the amount that futures can be taxed once sold. According to Investopedia, this section dictates the long and short-term capital gains taxes that can be applied to futures sales.
- Time Decay: The value of options is known to decrease over time, causing them to be referred to as “time decaying” investments. This means investors can lose out on potential profits by waiting for the expiration date of a contract. Futures are not exposed to this same risk because the premiums are not the same.
- Asset Type: While futures and options can deal with the same asset types, they are generally used for different things. Options are most commonly used to buy and sell stocks, while futures are more common for commodities. This difference can help investors decide between the two, as both do require a strong knowledge of the underlying asset.
Futures Vs. Options: Which Is Best For You?
Both futures and options can be profitable investments — so how do you choose which one to add to your investment portfolio? The answer comes down to how comfortable you are speculating market changes. While options do offer a layer of protection against surprise changes in share prices, the fast-paced markets of futures can provide investors the chance to quickly make up losses. The best way to determine which strategy is for you often comes down to your comfort level with each scenario.
Some investors find it helpful to seek out the guidance of a broker or financial advisor before deciding between futures vs options. This can be a great way to ensure you are completely familiar with each market before making a decision, as they will often assess your overall understanding of the investment types. The most important thing to keep in mind as you choose which is best for you is that both can offer profit potential for your investment portfolio when managed correctly. And remember, nothing says you cannot trade both in time.
Summary
One of the best steps you can take for your portfolio is to diversify your overall investments. Let’s say you have a few successful rental properties or perhaps a budding stock portfolio, both futures and options offer the chance to expand your overall profit potential (and in some cases, minimize your overall risk). Choosing between futures vs options will come down to your comfort level and market understanding — but when managed correctly both can be great investment opportunities to consider.
Which do you prefer: futures or options? Share your investment experience in the comments below.
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