Options vs Futures the battle of the derivatives, we’ve seen it all over social media, which one is better to trade? Options or Futures? Which out of the two is riskier?
Both options and futures are derivative assets, meaning they involve large amounts of leverage which make it really attractive to speculators to get into those markets for the potential gains. However, we have to remember, with leverage, gains AND losses are both magnified so which one has a better risk profile? One of the key concepts to understand before diving into this is that you need to define your own risk tolerance and trading style which can help you determine which may be riskier and which you might lean towards trading.
What are Options?
Options contracts are derivatives assets between buyers and sellers, which gives the owner the right rather than the obligation to buy or sell the underlying financial instrument that the option is based on at an agreed-upon price at a specific time. A derivative asset is a leverage instrument in the financial market that is derived from a specific underlying meaning it has a higher leverage associated with it than the underlying. There are options available on equities, indices, futures, commodities, etc.
When trading an option in relation to stock, you will not guarantee the ownership of the underlying when holding options. Rather when you are involved in underlyings like owning the stock you hold the actual underlying in your account. Meaning if the stock pays dividends, and you hold the options, you will not be entitled to the dividends.
Options have a lot of terminologies, here are some of the most common things you need to know:
- Premium: Each option participant either receives or pays the price to get into the options which are called the premium. An options buyer pays the premium to the options seller. There are 100 shares associated with each option contract, meaning that you typically pay 100 times the quoted share premium for the 1 options contract. Assume you see an options contract that is priced at $0.50, you will pay $50 for this options contract.
- Strike price: This is also called the expiration price, the price the options seller is obligated to buy or sell at any time throughout the contract’s life.
- Expiration date: All options have a finite life, meaning they will expire at some point. Typically options standard expiration is the 3rd Friday of each month. There are many weekly options that expire each week, on most heavily traded equities. In some cases, the most liquid options (ETF based, like SPY, QQQ, IWM) expire 3 times a week. On Monday, Wednesday, and Friday. Some indices like SPX expire even more than that throughout the week!
- Puts & Calls: There are 2 types of options, the call options gives you the right to buy the underlying at a specific strike price until the expiration date. The put gives you the right to sell the underlying at a certain strike price until expiration.
For more information on options you can see this
What are Futures?
Futures are another derivative contract that is agreed upon between buyers and sellers, just like options. Those market participants agree on this specific security or commodity asset upon a specific expiration date as well. In the futures market, the buyer and seller of the contract agree on a deal that has price, quantity, and the future delivery date beforehand. Most futures contracts expire on a quarterly basis, every 3rd Friday of the quarter. Commodities like Oil have monthly expirations.
Futures contracts have buyers and sellers, the buy takes on a long position and if the price goes up they will make a profit as long as the price is now above their entry. There is no premium that goes into the futures market upon entry. You would simply enter and when you close the position you either have a realized loss or realized gain. If a seller gets into a trade, they would want the price to drop below their entry to generate a profit.
As a leveraged asset, futures can really provide traders with good opportunity, or a larger loss. The futures are $50X the index, meaning 1 point is $50. So you get a value that is 50 times the index price. Assume that the S&P500 E-mini index is trading 3850 right now, you are trading something that has $192,500 of value. However you are not buying 1 contract for that much, rather you put margin up for each contract. With AMP Futures the margin for 1 contract is $400, meaning the leverage is: (192,500/400)= 481X. If you get on the right side of a 10 point move, that is $50X10 which is a $500 gain.
Unlike options, futures do become worthless upon expiry. On expiration, a futures contract buyer is obligated to buy and receive the underlying security while the seller is obligated to provide and deliver that underlying security. There are cash-settled futures and physically settled futures, here are the most common:
- Commodity futures: Allow market participants to enter into the commodities space, where they can trade oil, gold, natural gas, orange juice and many many others.
- Financial futures: Allow market participants to enter into financial assets like indices, bonds, and even stocks. One of the most commonly traded futures contracts is the ES E-mini (S&P 500 futures).
Speculators typically will not hold futures until the expiration date, they will be in and out throughout the day or sometimes a few days. This is the same for retail traders as well.
For more information on futures trade, you can check out this full blog.
Ultimate Futures Trading Guide: Beginner to Expert
Understanding Risks in Derivatives.
Both derivatives in question here, options and futures are leveraged instruments. Meaning they inherently hold more risk than trading stocks, AND they are cheaper to enter and trade than stocks.
You can trade futures and options with $5,000 accounts, with $5,000 you can buy about 34 shares of AAPL at $145, meaning $1 move will be worth $34. Compared to options for example, if one AAPL contract costs $200, you get access to 100 shares per contract, even using half of your account you can buy 12 contracts, which magnifies to about 1200 shares (depending on the delta).
Your personal risk tolerance is a huge factor in this, technically futures are inherently riskier, they have higher leverage than options and they don’t have a capped max loss. Unlike buying options, the max you can risk is the full premium amount. When you enter into a futures contract and the price runs away from you, the whole account can be gone quickly. Futures can be more volatile because they’re more sensitive to smaller price movements and the increment of dollar per move reflects that. The S&P 500 futures reflect a $50 move per point, and the market moves 20-30 points quickly throughout the day.
Naturally, leverage has its pros and cons, a double edged sword if you will. You can profit a lot and quickly, but can lose just as easily.
Options buyers for calls and puts risk at a maximum their premium in the position. Sellers do have a much higher risk. If you are wrong as an options buyer, you can see your options expire worthless.
Futures have an unlimited liability usually, brokers will close you out if you reach a margin call level. For example with a $3,000 account if you are down 60 points on the ES futures you will blow your account and have your position closed out.
PROS & CONS of Options vs Futures
For US traders, one of the biggest PROs of futures trading is that there is no pattern day trading rule that you have to follow.
| Futures | Options | ||
| PROS | CONS | PROS | CONS |
| Leverage: We looked at how much leverage futures have above. 480X the index, most brokers allow traders to trade with a margin requirement of 3-10% on average. With this much leverage you can trade a smaller account and generate larger returns. | With leverage, you will inherently take on more risk. Remember this is a double-edged sword, you can make as much as you can lose. | Leverage: Options provide multiple overexposure to the underlying. Each contract holds 100 shares of whichever underlying you’re looking at, equity-wise. Your profits can be magnified by 100X (depending on the delta) compared to that of the stock. | Options have a finite lifetime, so the contract has to move in your direction if you are long or directional otherwise you will forfeit your full premium. Options are sensitive to time and movement, even with leverage, you will need to get a larger move in your direction if the position originally goes against you. |
| Diversification/Hedge: Futures allow traders to add a leverage component to their trading style or portfolio that can diversify or hedge out other positions. They allow market participants exposure to commodities and indices. | If the hedge or diverse position doesn’t have a stop and it goes against you, you can stand to risk a lot more than planned. You can get a margin call if you’re not watching the position. | Cheap to enter: Options are a lot cheaper than stocks to enter, they also have smaller margins than futures to enter. | Some options that are extremely cheap will attract buyers to speculate on the movement. This is usually a trap, if you go farther out to buy a super cheap option, the likelihood it’s getting sold to expire worthless is high. |
| Time: Futures trade overnight and throughout the regular trading session. You have access to the market from 6 PM EST to 5 PM EST the next day, each day. They open at 6 PM EST on Sundays as well. | There is an hour when the futures market is closed, between 5 PM EST and 6 PM EST, along with the weekends. Where price can experience gaps up or down. Even though they trade overnight, there could be violent swings while you’re asleep. | No obligation: Options buyers don’t have the obligation to buy the underlying. You don’t have to exercise the underlying if you have a profit. | As an options seller, you will have to hold up your end of the bargain if the position is in the money and the buyer wants to exercise. |
Overall, these inherently risky derivatives have a lot of opportunity, and which is riskier than the other also depends on your risk tolerance. You will have to find out what your trading style is and what your risk tolerance is so you can make the decision. Luckily at TRADEPRO Academy, we trade both options and futures and you can learn how to do so while managing risk.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
