Futures vs Options: 3 Simple Questions To Ask Before Trading
Don’t get lost in the jargon. When considering futures vs options, ask yourself these three simple questions to understand the key differences and decide whether it is the method of trading for you.
1. Do you know the difference between options and futures?
Futures vs options boils down to two different trading scenarios:
- Options grant you, the trader, a choice in whether to buy or sell a specific share, at a specific price, for the duration of a contract, with a specific stockholder.
- Futures take away your option. Once you enter the contract, whether it is to buy or sell, the agreed-upon shares must be transacted by a specific date.
Simply put, both scenarios are trading, which is riskier than straight-forward investing in shares or bonds.
2. Can you honor trading commitments, even if it means losing money?
The best way to explain how trading in futures works is through considering a scenario. Here’s an example:
- You agree with another trader to pay $40 per bushel of corn by the end of the next quarter.
- This is a gamble on your knowledge of whether the price per bushel will be above or below what you’ve promised to pay.
- If the price per bushel is $50 by the end of the quarter, you’re paying $10 per bushel under the price. You’re making a profit.
- However, if the price per bushel is $30, you’re paying $10 over the going rate.
The whole point of trading in futures is to try and get a deal with a trader who is betting on the opposite of you. You agree to pay $40, believing it’ll be worth more, while the seller agrees to sell at $40, because they believe it’ll be worthless.
If you don’t like gambling with big lumps of cash, trading futures is not for you.
3. Do you want to hedge your trading bets?
When trading in options, there are two considerations:
- Call Options: This is the option to buy a stock.
- Put Options: This is the option to sell a stock.
An options contract consist of; the strike price (valuation), an expiration date, and the asset in question. For example, 100-shares of a specific stock.
Here’s an example of how trading in options works:
- You, the trader opens a call option to buy a specific stock at $100 per share, within the next 30-days. The stock is currently trading at $95. Opening the option has a premium fee.
- The stock jumps to $105 within those 30-days.
- You, the trader has the right to buy that stock at $100 for the duration of your contract. Meaning you can immediately make a profit of $5 per share.
- On the flip side, if the stock falls to $90 you can let the contract expire, but you’ll lose the premium fee you’ve paid.
Effectively, trading in options is the same as futures, without the commitment. Instead, you’re risking your premium fee. So, regardless of whether it’s futures vs options, you’re taking a bigger risk than necessary. This route is suitable for the investor who can afford to take bigger risks for bigger rewards. If you cannot afford to lose the money your trading, don’t take the risk. Simple.