Some novice investors toss around the terms options and futures like they are interchangeable, when in fact, they are actually two very different things. Both involve the purchase or sale of a future commodity such as stocks or bonds, but the conditions of the sale are what set them apart. Options and futures are also both ways to hedge your investments, which means they reduce your financial risk if the market goes sour.
In the stock market, a futures contract is an agreement between two parties to buy or sell a set amount of stocks by a predetermined date. However, where this gets tricky, is that investors can also sell their futures contract. Investors are typically in the long position because they agree to buy the stocks. Businesses are in the short position because they agree to sell the stock according to the terms of the contract. However, investors can go short if they sell the futures contract. Typically investors pay an upfront 20% investment called a margin. During the term of the contract though, they never actually own the stocks; they just have the rights to purchase the stocks at a later date. For example, say you agree to buy 200 shares of Apple stock at $100 per share by June 1st. Your futures contract is worth $20,000 at the time you enter the agreement. If the stock goes up to $125, you can sell the contract early and make a considerable profit. If the value of the stock goes down, you will lose more than your initial investment. Futures are considered a high-risk investment. Once you enter into a futures contract you are obligated to buy or sell that stock upon expiration unless you sell the futures contract to someone else first.
The biggest difference between futures and options is that with an option contract you are not obligated to purchase the commodity when the contract comes to term. However, you do have to pay an upfront premium fee. If you choose not to purchase the stocks then you forfeit the premium fee. Returning to the Apple example, you can purchase an options contract to buy 200 shares of stock at $100 each for $2,000. If for some reason the stock plummets to $100 per share, you can forfeit your option and you only lose the premium fee of $2,000 instead paying $20,000 for stock that is only worth $10,000. Because investors are not obligated to fulfill options contracts as they were with futures contracts, options are considered a much lower-risk form of investment.
Any type of speculative investment comes with risk. Although options are safer than futures, both should be approached conservatively if you are a novice investor. Most investors that buy futures and options have years of experience with the stock market and top-notch financial advisors. However, if you are interested in trading stocks and futures than it is a good idea to speaking with a reputable financial advisor before making any investments.
About the Author: Natisha Antill is a finance student who is seriously considering entering the world of day trading when she has more time to focus on a plan. She enjoys reading Timothy Sykes reviews and studying the procedures used by today’s most successful traders.