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Options and Futures: Similarities and
Differences
You often see the phrase 'options and futures', as if the two
were financial Siamese twins. But, though similar, there are
important differences the savvy investor should keep in
mind.
Both are so-called derivatives, since they have no independent
worth as an asset, but derive their value from the instrument
they are related to. However, there is an essential difference
between the pair. Both are contracts binding two parties, but
the terms of that contract define the difference.
A futures contract gives its buyer the obligation to purchase
the underlying asset and the seller to sell (and deliver) it at
a preset date. (If the futures holder liquidates his position
prior to expiration, the delivery clause is voided,
obviously.)
By contrast, an options contract, whether a call (buy an asset)
or put (sell an asset), grants the holder the right - but not
the obligation - to exercise the option. The holder is entitled
to simply let the option expire without investing further.
Investors can enter futures contracts without inputing any
funds (ignoring any commission), but an option always carries a
cost - the 'premium'. (Note: This is only partially accurate
since, in practice, futures contract buyers typically put down
a deposit of around 10% of the price of the underlying asset.
But the futures contract itself doesn't cost anything but a
small commission.)
Futures contracts typically represent a larger investment in
the underlying asset. (At least from the standpoint of a legal
obligation, if not actual money laid out.)
The contract requires the buyer to either purchase the 'goods'
by the deadline (which is rare), or sell the contract to
another party. So, the financial obligation is, at least in
principle, potentially very large.
The risk in options is therefore lower, with the amount limited
to the premium cost.
Nevertheless, few traders actually take delivery of several
tons of wheat or a few thousand barrels of oil. The contracts
typically are actively traded until just before settlement
time, at which time a buyer - one appropriate to that commodity
- purchases the actual goods and re-sells them.
(Of course, futures contracts exist on non-physical 'goods' as
well - such as index futures, bond futures, even futures on
options!)
Similarly, only a small percentage of options traders actually
take delivery of the underlying shares of stock, bond
certificates, commodity or other instrument. (Some do, such as
employees of companies granting options as part of employment
compensation packages. And a small percentage of a very large
number is still a substantial number of individuals.)
There are also important differences in the way profits (or
losses) are realized from the two contracts.
A call option, for example, that is 'in the money' can be
purchased and exercised immediately. 'In the money' means the
'strike price' - the price at which the underlying asset must
be bought or sold via the option - is lower than the current
market price.
For example, in April a June 17 call on Microsoft might have a
strike price of $25, with a current market price of $27 per
share. Assuming the cost of the option (and commissions)
averages less than $2 per share the investor can realize an
immediate profit by selling the call or exercising the
option.
Futures gains, on the other hand, are automatically 'marked to
market' daily. I.e. the any change in the value of the position
is adjusted in the accounts of the contracting parties at the
end of every trading day.
Like stock prices, of course, the gain or loss is 'only on
paper'. Unlike stocks however, that 'paper loss' can become
very real when the contract expires and the holder is forced to
liquidate.
Both instruments carry risk, but are valuable for the leverage
they offer - the ability to control more funds than you
invest.
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