What sets options and futures apart in the field of finance?

In recent years, futures and options have gained significant popularity among investors, particularly in the stock market. This surge in popularity can be attributed to their numerous advantages, including reduced risk, leverage, and high liquidity.

Futures and options fall under the category of derivatives, financial instruments whose value is derived from an underlying asset. Derivatives are available for a wide range of assets, such as stocks, indices, currencies, precious metals like gold and silver, agricultural commodities like wheat and cotton, and energy resources like petroleum. Essentially, any tradable financial instrument or commodity can be associated with a derivative.

Futures and options serve two primary purposes: hedging and speculation. In markets where prices can be highly volatile, they provide a valuable tool for hedging against potential losses, benefiting producers, traders, and investors.

Speculators, on the other hand, utilize these derivatives to profit from price fluctuations. By accurately predicting price movements, speculators can capitalize on opportunities presented by these financial instruments.

Options

Options are financial instruments that derive their value from an underlying asset, which can be a stock, index future, or commodity. When you have an options contract, it grants you the right to buy or sell the underlying asset at a specific price during the contract's validity. Importantly, you're not obligated to exercise this right; it's a choice left to the investor.

It's crucial to understand that options are a type of financial derivative. Owning an option doesn't mean you own the actual shares of the underlying asset, nor do you have the privileges of a shareholder unless you decide to exercise the option to purchase stock.

In the context of stocks, options contracts typically involve the ability to buy or sell 100 shares of the stock at a predetermined price, known as the strike price. The cost of the option is referred to as the premium.

There are two fundamental types of options: call options and put options. A call option gives you the right to buy a stock at the strike price before the contract expires, while a put option grants you the right to sell a stock at a specific price.

For instance, let's consider a call option example: Suppose an investor purchases a call option for stock XYZ with a strike price of $50, valid for the next three months. At the time of purchase, the stock was trading at $49.

If the stock's price later rises to $60, the call option holder can choose to buy the stock at the agreed-upon $50 price. Subsequently, they can sell the stock at the current market price of $60, resulting in a $10 profit per share.

Futures

A futures contract entails a commitment to either purchase or sell an asset at an agreed-upon price on a specified future date. Futures contracts are most commonly associated with commodities such as corn or oil, and they serve as a genuine hedge investment.

To illustrate, consider a situation where a farmer wishes to secure a favorable price for their crop in case market prices decline before the crop's delivery. Conversely, a buyer may opt for a futures contract to lock in a price and guard against potential price hikes.

To exemplify this, let's take the scenario of two traders agreeing on a corn futures contract at $7 per bushel. If the price of corn subsequently rises to $9, the contract's buyer gains $2 per bushel, while the seller misses out on a more advantageous deal.

The realm of futures trading has greatly expanded beyond commodities like oil and corn. Nowadays, futures contracts can be acquired for a wide array of assets, including indexes like the S&P 500 and, in certain jurisdictions, individual stocks (although single-stock futures have not been available in the U.S. since 2020).

Importantly, purchasers of futures contracts are not obligated to pay the entire contract value upfront. Instead, they are typically required to provide an initial margin, which represents a percentage of the contract's total value.

For instance, let's consider an oil futures contract for 1,000 barrels of oil, with a price of $100 per barrel. Entering into this contract would involve a risk of $100,000. Initially, the buyer might only need to put down a fraction of this amount as an upfront payment, with the potential for an increase in this commitment if oil prices subsequently decrease.

Who Trades Futures?

Futures markets play a crucial role for various participants, including those involved in producing and consuming commodities, as well as speculators. These markets offer a valuable means of safeguarding both buyers and sellers against significant price fluctuations in the underlying commodities.

Additionally, futures markets are accessible to both institutional and individual traders who aim to capitalize on anticipated shifts in market prices for the underlying assets or commodities. Notably, financial speculators in these markets typically do not have the intention of taking physical possession of the underlying commodities upon contract settlement, and they are more inclined to sell their positions before that point.

Examples of Options and Futures

To further illustrate the differences between options and futures, consider the following examples:

Options: An options investor might have purchased a call option for a premium of $3.00 per contract with a strike price of $1,750 expiring in August 2022, linked to one COMEX gold futures contract. This call option would have allowed the holder to take a bullish stance on gold, with the right to assume the underlying gold futures position until the option's expiration.

If the price of gold exceeded $1,750, the investor could exercise the right to buy the futures contract, with the maximum potential loss being the $3.00 premium paid.

Futures: Alternatively, the investor could have chosen a futures contract on gold. One futures contract represents 50 troy ounces of gold. The buyer is obligated to receive 50 troy ounces of gold from the seller on the specified delivery date in the futures contract.

Assuming the trader has no intention of taking physical possession of the gold, the contract would be sold before the delivery date or rolled over into a new futures contract. As the gold price fluctuates, the investor's account is credited or debited daily. If the market price of gold falls below the contract price, the futures buyer is still required to pay the higher contract price on the delivery date.