Both futures and options are relatively advanced investment tools that average investors don’t commonly use without some form of training. They can both, however, be very useful supplements for an advanced investor and this article will provide a preliminary background on how to use futures vs. options.
A futures contract is one where the two parties of the contract are obligated to buy or sell an asset at a specified price at some point in the future, typically less than one year.
The asset in question can vary but typically futures contracts are used in commodity trading or for shares.
Futures are very commonly used by companies that require a specific commodity for their business and the company wants to lock in a price for that commodity. By entering into a futures contract with a seller they know well in advance exactly what their cost will be and can plan around that. An example of this would be Starbucks entering into futures contracts with coffee growers and sellers to ensure an adequate supply at a clear price well in advance of when they need it.
Futures can also be used to hedge a company’s risk exposure for a certain product they typically buy or sell, where even though they do not intend to take delivery of the goods (or sell them physically) they can insulate them from significant price changes. This is largely facilitated by futures trading markets, like the Chicago Mercantile Exchange, where futures are traded but the actual transfer of physical goods is not.
The risk in futures trading is that the contract is an obligation to buy or sell, so trading with no intention of possessing the underlying asset can be costly. If you purchase a futures contract to buy 10 tons of coffee for $20 an lb. in one year, and after a year the price of coffee is actually $10 an lb. it will be very costly for you to sell that contract to another party if you don’t want to actually buy the coffee. This is where futures trading requires careful monitoring and a clear understanding of your risk exposure. Some futures contracts can be entered into at minimal cost, but depending on the terms certain futures contracts can have significant upfront costs for the buyer or seller.
An options contract is where the buyer of the option purchases the right, but not the obligation, to buy or sell an asset at a specified price over a certain time period. Options are most commonly used with shares as the underlying asset, but they can be structured to relate to any sort of investment tool.
Options are very commonly used by investors to bet that a stock price will go up or down without actually purchasing the underlying stock. If a call option is purchased the investor is buying the right to purchase a stock at a specified price over a set time period, so they are betting that the actual price of the stock will be higher. This way they can buy the stock at the price in the contract and then sell it immediately for a profit. A put option is buying the right to sell a stock at a specified price over a set time period, so a bet that the actual price of the stock will be lower. This way they can buy a share and then sell it through their put option for an immediate profit.
Options are also commonly used as employee incentives, where performance or years worked rewards will give employees discounted call options. This way the employees can buy relatively cheap shares in the company and either hold them or sell them for an immediate profit.
When it comes to investing in futures vs. options the key issue comes down to risk exposure. While options provide the right to do something, futures provide the obligation to do so and have the potential to result in substantial losses. Both futures and options are fairly complex investment tools and aren’t recommended for anyone without training in how to effectively use them. Alternatively, consulting specialists or hiring a specialist manager to handle trading in these tools is a very common alternative.