Futures contracts and options are both derivatives, but the key difference lies in the obligations they create: futures obligate you to buy or sell an asset, while options give you the right (but not the obligation) to do so.
Futures Contracts
A futures contract is an agreement to buy or sell an underlying asset at a predetermined price at a specified future date.
- Obligation: Both the buyer and seller of a futures contract are obligated to fulfill the contract at expiration. The buyer must purchase the asset, and the seller must deliver it.
- Profit/Loss: Profit or loss is determined by the difference between the agreed-upon price and the market price at the settlement date.
- Example: A farmer enters into a futures contract to sell 5,000 bushels of corn at \$5 per bushel in six months. Regardless of the market price of corn in six months, the farmer must sell the corn at \$5, and the buyer must purchase it at \$5. If the market price is higher than \$5, the buyer loses, and the farmer wins. If the market price is lower than \$5, the farmer loses, and the buyer wins.
- Common Uses: Hedging (reducing risk), speculation (profiting from price movements).
Options Contracts
An options contract gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specific price (the strike price) on or before a specific date (the expiration date).
- Right, Not Obligation: The buyer of an option can choose whether or not to exercise the contract. The seller (or "writer") of the option is obligated to fulfill the contract if the buyer chooses to exercise.
- Premium: The buyer of an option pays a premium to the seller for this right. This premium is the maximum loss the buyer can incur.
- Types:
- Call Option: Gives the buyer the right to buy the underlying asset.
- Put Option: Gives the buyer the right to sell the underlying asset.
- Example: You buy a call option for a stock with a strike price of \$100, expiring in one month, for a premium of \$2. If, at expiration, the stock price is \$110, you can exercise your option, buy the stock for \$100, and immediately sell it for \$110, making a profit of \$8 (\$10 profit - \$2 premium). If the stock price is below \$100, you simply let the option expire worthless, and your only loss is the \$2 premium.
- Common Uses: Hedging, speculation, income generation (selling options).
Futures vs. Options: A Comparison
Feature | Futures Contract | Options Contract |
---|---|---|
Obligation | Obligation to buy or sell at expiration | Right (but not obligation) to buy or sell |
Premium | No upfront premium | Premium paid by the buyer to the seller |
Profit/Loss | Theoretically unlimited profit and loss | Limited loss (premium paid), potentially unlimited profit |
Risk | Higher risk due to obligation | Lower risk for buyer (limited to premium) |
Exercise | Always exercised at expiration | Exercised only if profitable for the buyer |
In summary, futures contracts are binding agreements to buy or sell an asset at a future date, while options contracts offer the right, but not the obligation, to do so. This difference in obligation leads to different risk profiles and applications.