An Easy Guide to Understanding the Difference between Futures and Options

A dilemma that faces both new and experienced investors is the decision to transact on futures or options. The two products are similar in that they are agreements between a buyer and a seller to complete a transaction at a set price and before the expiry of a specific time. They provide investors with hedging against investment risk.  

Despite this similarity, there is a significant difference between futures and options. Like any other financial product, understanding this difference makes it easier to choose the method that suits your needs best. 

Defining the Terms

An options contract refers to an agreement between investors – a buyer and a seller. The agreement is to complete a transaction of stated security at a specified price before the end of a set period. This set price is referred to as the strike price.  

It can be a call option or a put option. A call option is where an investor makes an offer to purchase security before the expiration date while a put option is where the investor makes the offer to sell a security before the set date. Ownership only occurs after the finalization of the agreement.

A futures contract, on the other hand, is a type of agreement that requires the buyer and purchaser to complete the transaction on a specified date and for the preset price.  

Difference between Futures and Options

A major difference we can derive from the definition of the terms is in the options available for the participants in either case.

The investors in an option are not obligated to complete the transaction on the expiration date. They can transact when the option is in a position to create value or when it is in the money.

Future contracts should be completed on the expiration of the contract date regardless of the price of the security at the time. It makes futures riskier than options and brings us to the next point – the need for a premium.

With an option, a premium is paid to the option writer, who is the investor who opens the put option. This premium varies throughout the contract. The buyer of the call option pays it. For this reason, the profit or loss made on an option will vary depending on the amount of premium paid.

Futures, however, do not carry a premium because both parties carry equal rights, unlike in options.

Another difference between futures and options is the size of the transaction. Futures tend to be of larger amounts compared to options.   

In Conclusion

Knowing the difference between futures and options puts you in a better position to decide between the two. Although options provide the buyer with the right to buy the underlying asset before the expiration date, it is not an obligation. Future options are an obligation set on both the buyer and seller. It makes futures riskier than options.

With this understanding, you can make a better investment decision and properly mitigate the risk that price movements present.