In the past few years, derivatives market has become increasingly important in terms of finance and investments. An average person with no market knowledge would think that you only make money when the markets go up. But, the fact is you can also make money when the markets go down. This is where futures and options come in.
Now, futures and options are two financial derivative instruments that obtain their value from the value of another asset, such as stock, bond, commodity, or currency. They allow investors to hedge against risk or speculate on the underlying asset’s future price movements. When the underlying asset’s value fluctuates, the value of derivatives such as futures and options fluctuates as well. We look at some common features between futures and options.
Futures is a major financial instrument that is traded in the derivatives market. Futures are basically an obligatory contract, kind of an agreement, to buy or sell an underlying asset at a certain time in the future for a certain price. There are many exchanges in the world trading in futures contracts. Two of the largest futures exchanges in the world are the Chicago Mercantile Exchange (CME) Group and the Chicago Board of Trade (CBOT).
Futures contracts are highly standardized, which means the asset’s quantity, quality and delivery date are predetermined. They are frequently used for price hedging or as a form of leverage to magnify potential gains or losses. They are often used as a means of hedging against price fluctuations or as a leverage to increase potential gains or losses. They buyer must buy or the seller must sell the underlying asset at the agreed-upon price.
Options are yet another form of derivative contract that offer a good opportunity to make money trading in volatile times. Like futures, options are contracts but not obligatory contracts, meaning it gives buyer the right, but not the obligation, to buy or sell an underlying asset, such as stocks, at an agreed-upon price on or before a certain date. They are traded on options exchanges and can be used for income, to speculate, and to hedge risk.
The options market is an investment derivative that truly goes hand in hand with the futures market. Like futures, they have expiration dates. When used properly, options trading give you a great chance to diversify your holdings beyond traditional investments and to hedge your portfolio against future risks. However, it does not give the holder any share of the underlying security. The right to buy or sell that security is the key to options trading.
Similarities between Futures and Options
- Underlying Asset – Both futures and options are major financial instruments that obtain their value not from their own intrinsic value but rather from the value of an underlying asset, such as stock, bond, commodity, or currency. They are contracts that bind the seller and the buyer under an agreement for trading a stock or index at an agreed-upon price and date. Both futures and options contracts have expiration dates
- Leverage – Futures and options both allow investors to control a larger portion of the underlying asset with a relatively smaller amount of capital, a process known as leverage. This gives you the potential to gain large returns relative to the amount of money invested, but it also carries a high level of risk. However, one great advantage of trading in futures versus options is that you have more leverage.
- Risk – Because the futures and options prices depend on the prices of those underlying assets, they carry no guarantees but a significant amount of risk. Risk management is an overlooked area of trading. Futures are more risky because they involve a greater degree of leverage. However, risk can be managed by implementing hedging strategies such as purchasing and selling other derivatives or underlying assets.
- Price Discovery – Both the markets create a marketplace for buyers and sellers to continuously evaluate supply and demand factors and other market indicators. Based on current market analysis about expectations and information of future price swings, trades are made and prices are discovered. This can provide valuable information to investors while also assisting in market stabilization.
- Margin – To participate in the market, both futures and options require investors to put up margin, or a percentage of the contract value. This serves as collateral and ensures that both parties fulfill their contractual obligations. Margin requirements can differ depending on market conditions and the contract being traded.
The derivatives industry is constantly changing to fulfill the need of those who use them. So, trading in futures and options require a higher level of market knowledge and experience to use effectively. Both are based on an underlying asset and are traded in contracts, which specify the quantity, quality, and expiration date of the underlying asset, such as stock, bond, commodity, or currency. They require margin from investors and can be managed with smart hedging strategies.
What are futures and options with example?
Futures contract is a legally binding contract that put the buyer and seller under the obligation to meet the conditions for the delivery of commodities or financial instruments at a pre-determined time. Options contact is not obligatory.
For example, an investor could purchase a futures contract for 100 shares of Company A stock at $50 per share with a three-month delivery date, or they could purchase a call option for 100 shares of Company A stock at $55 per share with a three-month expiration date.
Which is better options or futures?
Both futures and options are basically derivatives of other assets that are traded in the markets. Options provide greater flexibility and potentially higher returns, but they also carry a higher level of risk. Futures are often easier to understand, have greater margin, and are often less risky. So, a better understating of the market and its risks is important.
What is the difference between stock options and futures options?
Futures options are based on futures contracts, which in fact are based on commodities or financial instruments, whereas stock options are based on individual stocks.
Is it good to invest in futures and options?
While both can be extremely rewarding, they are very risky, and a single bad trade can wash out all your profits. While futures and options trading can be a great way to make money in the stock market, they can be a risky proposition as well.
Why are futures and options so risky?
Futures and options are instruments of leverage, so carry a great amount of risk. The profit or loss on futures and options contracts is determined by changes in the price of the underlying asset, which can be unpredictable.
How to trade futures for beginners?
As a beginner, you should first do a thorough market research, understand the dynamics of futures contracts, and create a trading strategy. You should also consider the risks involved and consider practicing with a demo account before trading with real money.