The biggest difference between options and futures is that futures contracts require that the transaction specified by the contract must take place on the date specified. Options, on the other hand, give the buyer of the contract the right — but not the obligation — to execute the transaction.
Both options and futures contracts are standardized agreements that are traded on an exchange such as the NYSE or NASDAQ or the BSE or NSE. Options can be exercised at any time before they expire while a futures contract only allows the trading of the underlying asset on the date specified in the contract.
There is daily settlement for both options and futures, and a margin account with a broker is required to trade options or futures. Investors use these financial instruments to hedge their risk or to speculate (their price can be highly volatile). The underlying assets for both futures and options contracts can be stocks, bonds, currencies or commodities.
What are Futures?
Futures contracts are agreements to trade an underlying asset at a future date at a pre-determined price. Both the buyer and the seller are obligated to transact on that date. Futures are standardized contracts traded on an exchange where they can be bought and sold by investors.
What are Options?
Options are standardized contracts that allow investors to trade an underlying asset at a specified price before a certain date (the expiry date for the options). There are two types of options: call and put options. Call options give the buyer a right (but not the obligation) to buy the underlying asset at a pre-determined price before the expiry date, while a put option gives the option-buyer the right to sell the security.
Options are Optional, Futures are Not
One of the key differences between options and futures is that options are exactly that, optional. The option contract itself may be bought and sold on the exchange but the buyer of the option is never obligated to exercise the option. The seller of an option, on the other hand, is obligated to complete the transaction if the buyer chooses to exercise at any time before the expiry date for the options.
Why Are Options and Futures Used?
Many businesses use options and futures to hedge their risks, such as exchange rate risk or commodity price risk, to help plan for their fixed costs on items that frequently change in value. For example, importers may protect themselves from the risk of their home currency falling in value by buying currency futures that give them more certainty in their business operations and planning. Similarly airlines may use options and futures in the commodities market because their business depends heavily on the price of oil. Southwest Airlines famously reaped the rewards of their hedging strategy for oil prices in 2008 when the price of a barrel of oil reached over $125 because they had purchased futures contracts to buy oil at $52.
Prices for options and futures contracts are highly volatile — much more so than the price of the underlying asset. So investors may also use them for speculating. Brokers require margin accounts before they allow their clients to trade options or futures; often they also require clients to be sophisticated investors before they enable such accounts because volatility and risks with options and futures trading are significantly higher compared with trading the underlying asset e.g. stocks or bonds.
Options can be used to reserve the right to purchase or sell an item at a predetermined price during a set time period. For instance, a real estate investor might hold an option to purchase a piece of property during a time period while they determine if they can get the funding and permits they need. Such options, although not exchange-traded, give the buyer the “right of first refusal” when someone makes an offer on a property.
Important Options and Futures Terminology
For both options and futures, there are certain terms that are important to know. In the world of options, the terms “put” and “call” are key to the business. A “put” is the ability to sell a certain asset at a given price. A “call” is the ability to purchase an item at a pre-negotiated price. The price itself is called a “strike price” or an “exercise price.” In addition, options usually come with an “expiration date.” This date is the date by which the option would need to be put into action, otherwise the option will become null and void.
Futures have their own terminology as well. The “exercise price” or “futures price” is the price of the item that will be paid in the future. Buying an item in the future means that the purchaser has gone “long.” The person selling the futures contract is called “short.”
What can be Optioned?
There are many items that can be optioned. Options can be exercised on a wide variety of stocks, bonds, real estate, businesses, currency and even commodities. Frequently used in the investment world, options can also be used by privately held companies and individuals as a way to hold the right to purchase or sell something of value. Options do not guarantee a sale; they only provide the right to it.
What assets can be covered under a Futures contract?
Futures cover a myriad of items. Futures can be traded for currency, stocks, interest rates and other financial vehicles as well as commodities such as crude oil, grain and livestock. Unlike options, a futures contract is binding and the contract must be fulfilled per the terms of the agreement.
Popularity in the financial industry
Futures and options are a significant part of the financial trading industry and are roughly equally popular, with options having a slight advantage in volume. According to FuturesIndustry.org, during the first half of 2012, 5.46 million futures contracts and 5.66 million options contracts were traded.