Options vs. Futures: What’s the Difference?

An options contract gives an investor the right, but not the obligation, to buy (or sell) shares at a specific price at any time, as long as the contract is in effect. By contrast, a futures contract requires a buyer to purchase shares—and a seller to sell them—on a specific future date, unless the holder's position is closed before the expiration date.

Options and futures are both financial products investors can use to make money or to hedge current investments. Both an option and a future allow an investor to buy an investment at a specific price by a specific date. But the markets for these two products are very different in how they work and how risky they are to the investor.

KEY TAKEAWAYS

• Options and futures are similar trading products that provide investors with the chance to make money and hedge current investments.
• An option gives the buyer the right, but not the obligation, to buy (or sell) an asset at a specific price at any time during the life of the contract.
• A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date unless the holder's position is closed prior to expiration.

Options

Options are based on the value of an underlying security such as a stock. As noted above, an options contract gives an investor the opportunity, but not the obligation, to buy or sell the asset at a specific price while the contract is still in effect. Investors don't have to buy or sell the asset if they decide not to do so.

Options are a derivative form of investment. They may be offers to buy or to sell shares but don't represent actual ownership of the underlying investments until the agreement is finalized.

Buyers typically pay a premium for options contracts, which reflect 100 shares of the underlying asset. Premiums generally represent the asset's strike price—the rate to buy or sell it until the contract's expiration date. This date indicates the day by which the contract must be used.

Types of Options: Call and Put Options

There are only two kinds of options: Call options and put options. A call option is an offer to buy a stock at the strike price before the agreement expires. A put option is an offer to sell a stock at a specific price.

Let's look at an example of each—first of a call option. An investor opens a call option to buy stock XYZ at a $50 strike price sometime within the next three months. The stock is currently trading at $49. If the stock jumps to $60, the call buyer can exercise the right to buy the stock at $50. That buyer can then immediately sell the stock for $60 for a $10 profit per share.

Other Possibilities

Alternatively, the option buyer can simply sell the call and pocket the profit, since the call option is worth $10 per share. If the option is trading below $50 at the time the contract expires, the option is worthless. The call buyer loses the upfront payment for the option, called the premium.

Meanwhile, if an investor owns a put option to sell XYZ at $100, and XYZ’s price falls to $80 before the option expires, the investor will gain $20 per share, minus the cost of the premium. If the price of XYZ is above $100 at expiration, the option is worthless and the investor loses the premium paid upfront. Either the put buyer or the writer can close out their option position to lock in a profit or loss at any time before its expiration. This is done by buying the option, in the case of the writer, or selling the option, in the case of the buyer. The put buyer may also choose to exercise the right to sell at the strike price.

Futures

A futures contract is the obligation to sell or buy an asset at a later date at an agreed-upon price. Futures contracts are a true hedge investment and are most understandable when considered in terms of commodities like corn or oil. For instance, a farmer may want to lock in an acceptable price upfront in case market prices fall before the crop can be delivered. The buyer also wants to lock in a price upfront, too, if prices soar by the time the crop is delivered.

Examples

Let's demonstrate with an example. Assume two traders agree to a $50 per bushel price on a corn futures contract. If the price of corn moves up to $55, the buyer of the contract makes $5 per barrel. The seller, on the other hand, loses out on a better deal.

The market for futures has expanded greatly beyond oil and corn. Stock futures can be purchased on individual stocks or on an index like the S&P 500. The buyer of a futures contract is not required to pay the full amount of the contract upfront. A percentage of the price called an initial margin is paid.

For example, an oil futures contract is for 1,000 barrels of oil. An agreement to buy an oil futures contract at $100 represents the equivalent of a $100,000 agreement. The buyer may be required to pay several thousand dollars for the contract and may owe more if that bet on the direction of the market proves to be wrong.