What Are the Differences Between Futures And Options?

December 8, 2021

Stock option trading has become extremely popular among retail investors. The rise of online brokerages has opened up access to option trading like never before. However, option contracts have a somewhat less popular cousin called futures contracts. Here’s a look at the similarities and differences between options and futures and an overview of which contracts might be a better fit for the average trader.

What Are Options?
A stock option contract is a derivative contract tied to a particular stock or exchange-traded fund. A stock option grants the buyer the right to buy or sell 100 shares of the underlying asset at a specific price by a specific future date. Stock option traders have no obligation to buy or sell the underlying security. They provide investors with the choice to buy or sell, hence the name “option.”

Call options grant buyers the choice to buy shares of stock, while put options give the buyer the choice to sell shares of stock. If an option buyer doesn’t want the contract to be executed, the buyer must sell the contract prior to its expiration date. Option writers, on the other hand, are obligated to carry out the other side of the trade if the buyer chooses to execute the contract. 

For example, a call option writer may sell a contract for 100 shares of Apple Inc. (NASDAQ: AAPL) stock at $150 with an expiration date of Dec. 15, 2021. If Apple’s stock price rises above $150 by Dec. 15, the call buyer will execute the contract, and the writer will be obligated to sell the buyer 100 shares of Apple at $150 per share. 

What Are Futures?
Futures contracts are derivatives that are essentially options without the optional part. When a futures contract is sold, the buyer and the seller are agreeing that a future transaction will definitely take place at a specific price on a specific future date.

Futures contracts can represent underlying assets such as commodities, currencies, or even stock indices, such as the Dow Jones Industrial Index. Futures contracts are often used as hedges against price changes in the underlying asset. For example, airlines can buy futures contracts to lock in future fuel prices or hedge against the possibility of a spike in oil prices. Rising fuel prices are totally out of the control of the airline industry but can have a dramatic impact on airline profitability.

In most cases, traders who hold futures contracts until expiration settle the position in cash rather than accepting delivery of the underlying asset. However, some futures contracts actually require physical delivery. This physical delivery requirement is the main reason the price of West Texas Intermediate crude oil futures contracts dropped well below $0 per barrel in 2020 when U.S. oil storage capacity was completely full. 

Which Derivative Is Best?
Futures contracts allow investors to make pure-play bets on commodities, currencies or metals that are difficult or impossible to access via the stock or options markets. Options allow traders to make bets on the future prices of individual stocks.

Option contracts provide more flexibility. They can be exercised at any point prior to the expiration date or not exercised at all. Futures contracts are only exercised on the expiration date and must be exercised. However, option buyers can pay a steep premium for that extra flexibility, and options contracts suffer time value premium decay as the expiration date approaches.

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