Wednesday, February 18, 2015

Futures vs Options

Options and futures are derivatives which mean that their values are derived from other financial instrument like stock. They are known as the most complicated financial instrument in the world.

Option is more complicated than futures. There is a formula on pricing options, so you can actually know weather an option is overvalue or undervalue. For me option is more interesting and challenging.
Both of them are contracts which act like an insurance against future price change. It can protect us from price drop and price hike. If you want to be able to sell stock XYZ at $ 50 you can buy a put option at $ 50. If the stock drops to $ 40, you can still sell it at $ 50. That is $ 10 profit. If you are a corn flakes producer, you need to buy corn to make corn flakes. So to insure that you have corn supply with current price, you need to buy corn futures at current price.

Futures and options have expiration date so it will expire some day. There are many differences between futures and options.
Option only gives the buyer the right but not the obligation. Future gives the holder the obligation to deliver the contract. Here's an example so you can understand it. Imagine stock XYZ is trading at $ 100. You can buy the call option which gives you the right to buy stock XYZ at $ 110. If stock XYZ traded at $ 120 before the options expire, you can buy the stock at $ 110 since you own the options. If the stock is at $ 90 you do not need to buy the stock at $ 110 and the options will expire worthlessly. In futures you must deliver the contract. So if you buy futures to sell a commodity at $ 100 you must deliver the commodity at $ 100 although the price is $ 120.
Futures contact usually has very huge position in underlying assets. It is riskier than options and is not suitable for newbie. Options price is lower than stock price. So with less money you can control more stock.
You do not need advance payment on futures but with options you need to pay premiums to receive the right.

Futures has unlimited loss and profit for long and short position. If you buy options you will have unlimited profit and limited risk which is the premium you paid. If you are writing options your profit is limited and your risk is unlimited.
Make profit with options using the right option strategy