Options and futures contracts are both derivatives, created mostly for hedging purposes. In practice, their applications are quite different though. The key difference between them is that futures obligate each party to buy or sell, while options give the holder the right (not the obligation) to buy or sell.
Jim thinks he might want to buy Tim’s house for $100k at some point in the future, but he is unsure. So Jim and Tim come to an option agreement, which gives Jim the right to buy Tim’s house for $100,000 at any time in the next year.
Jim has no obligation to buy the house. In exchange for extending Jim this right, Tim gets paid a premium of $5,000. Tim is obligated to sell his house for $100,000 if Jim chooses to exercise the option in the next 12 months.
Starbucks wants to hedge out any market risk associated with the production of coffee, so they come to a futures contract agreement with a coffee bean producer. They both lock in today’s market price.
Let’s say the contract’s delivery date is December 3rd, on that date, Starbucks has to buy the specified quantity for the specified price, and the coffee producer has to sell the coffee to them.
Futures are a contractual agreement between a buyer and a seller. The buyer agrees to buy an asset at a specified price at a specified date. Unlike options, both parties are obligated to buy or sell.
The beginning of futures trading in the modern world started with Japan and their Dojima Rice Exchange. Rice was the hottest commodity in Japan and people needed methods by which to exchange rice for cash simply, and rice exchanges allowed them to do so.
Nowadays, the main purpose of futures markets is still for hedging and so producers can receive cash for future production. Producers of commodities like oil, corn, and gold all utilize the futures markets.
An oil producer might only be able to profitably drill for oil when the price of crude oil is above $50 a barrel, so it would make sense for these producers to sell futures contracts around these prices to lock-in profitable production. If they’re wrong and the price of crude oil goes up, then they miss out on profits, but at least they don’t have to report production losses to their shareholders.
The most actively traded futures contracts are stock index futures. They carry liquidity, leverage and tax advantages over trading index ETFs. These are highly active because of how much money is managed in the stock market. Portfolio managers routinely use futures to hedge their exposure.
Options were also created out of the necessity to hedge. They have a history dating back to Ancient Greece, but their regulation began as late as the 1970s.
In an options agreement, there is a writer, the person who is selling the right, and a holder, the person is buying the right. The holder is buying the right to buy or sell an asset at a specified price, on or before a specified date. The holder has no obligation to exercise this contract, but the writer has an obligation to the holder.
During the Tulip Bulb Mania, options were not only used by producers and vendors to hedge against price volatility, but this is one of the first times in recorded history when options contracts became a tool for speculators, as they are today.
Initially, options were a shady business, used by institutions like bucket shops, with no guarantee of either party being able to hold up their end of the contract. The instrument was brought to legitimacy in 1973 when the Chicago Board Options Exchange (CBOE) was founded.
In the stock market, options are primarily used by portfolio managers to hedge against future uncertainty. If a PM wants to continue holding a stock but anticipates short-term downside, either because they think it’s a good long-term investment, or to defer capital gains taxes, options are a great way to offset any downside in the shares.
One of the simplest ways to use options for hedging is covered calls. This is a basic strategy that everyday investors can easily learn to use. Suppose you own 100 shares of XYZ and anticipate short-term downside, but you still desire to hold your shares. You can simply sell a call option against your share position. The buyer of this option will pay you a premium, which will provide income for your portfolio if shares decline in price.
Options are also used as a speculation tool. Suppose an activist short seller releases a scathing report against a company. After reading the report, you decide to bet against the stock in some fashion. Perhaps one way of expressing this view is through buying long-dated put options on the stock.
Options as a derivative have become a sort of asset class themselves, with their volume growing every year.
While options have never been known for their liquidity, certain contracts like those on index ETFs and futures have become quite liquid in recent years.
Pros of Options vs Futures
As a buyer of options, you have no obligation to act
If you buy an option, you have leeway. While you won’t get your premium back unless you sell the options contract to someone else, if your original market analysis was incorrect, you can always decide not to exercise the option and cut your losses.
Cheaper to speculate
Due to the overwhelming amount of choices that the options market affords you, there are some very cheap out-of-the-money options. While unlikely to expire in the money, they offer a very inexpensive way to make a cheap bet with an asymmetric risk-to-reward.
Options on smaller issues are much less competitive than futures markets. Many large arbitrage-focused funds don’t focus much on these smaller issues due to their low level of liquidity.
Most market participants can’t buy options on leverage. That means whatever price you buy your options for is the maximum loss you can experience. So long as you keep your options position sizing in check, it’s difficult to allow anyone options trade greatly affect your P&L.
Exercising happens on a predetermined date
Unlike an option, you cannot execute a futures contract before the delivery date. A vendor might delivery of a commodity early at the price in their agreement, but it doesn’t happen until the specified date. This is in contrast to options contracts, which gives the holder the right to exercise the contract at any time until expiration.
Pros of Futures vs Options
Futures markets are some of the most liquid markets in the world, making executing trades seamless and virtually instant without slippage. On the other hand, even the most liquid options markets generally still carry a wider bid-ask spread and are difficult to unload large positions quickly without significant market impact.
No Advance Payment
In a futures contract, you don’t pay your counterparty until the settlement date. This is in contrast to the options market, where the option buyer forfeits the premium upfront.
Your broker will typically have margin requirements that affect your buying power, but this money isn’t going to your counterparty.
No Time Decay
Futures contracts aren’t negatively affected by time decay because all futures contracts are executed at the contract price at settlement. So it doesn’t matter if you buy or sell a month or a day before the settlement date.
This is in contrast to options, which have to meet certain criteria to be profitably exercised, and as the date gets closer to expiration, they become less valuable because the market has less time to move.
Futures trading carries some inherent tax advantages over both options and stock trading due to section 1256 of the IRS code. This essentially means that every futures trade, regardless of trade duration, is taxed at 60% long-term capital gains rate and 40% short-term capital gains rate.
In the stock market, short-term stock and options traders are normally taxed at the short-term capital rate of 35%, which severely cuts into profits, especially compared to the much more favorable rate of 23% for futures trading.
Final Thoughts – Options vs Futures
While it’s easy to rag on Wall Street for the amount of “financial engineering” they do, the derivatives they create are normally due to demand from clients. Futures and options are two of the oldest derivatives around, both with histories going back as far as Ancient Greece.
Both derivatives have several applications for trading, arbitrage, hedging, etc. but for simplicity’s sake, I like to view it this way: options are like portfolio insurance. You write options against your stock positions that you have uncertainty about, and perhaps you buy put options on the stock index to hedge against market downturns.
The main purpose of futures is to allow producers, vendors, and consumers to hedge their production and inventory by “locking in” the current futures market price if it is profitable for them to do so.