Difference between options and futures – Option Trading FAQ

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This article will provide you with a detailed comparison of CFDs vs Futures, including definitions for both of these topics, together with, the differences between CFDs and options, how to use futures trading strategies, a practical example of futures trading, advantages and disadvantages of trading with CFDs and trading with futures, as well as several visual aids, to help you understand how these instruments look, and how to trade them.

It was in 1851 that the first futures contract was written. The product was corn and it occurred at the Chicago Board of Trade (CBOT). The plan was for the seller (who was a farmer) and the buyer (an industrial company) to commit to a future exchange of product for cash at a fixed price. Since then, futures trading has attracted more markets along with bringing even more buyers and sellers into the fold.

While the futures market is predominantly the arena for commercial and institutional traders, it also gave birth to the speculator – someone who profits from picking the correct future direction of a given market. But with the advent of technology and super fast computers, many traders have opted to trade on futures markets using CFDs (or Contracts for Difference). In this article we explain all there is to know about futures trading, CFDs, the pros and cons of each product, the markets you can trade in, and how to develop a strategy to benefit from both of these products.

What Are Futures?

The futures market originated in the commodities industry. It was farmers, miners and oil producers who wanted to manage the risk of not knowing the price they would get for their product in the future. This gave birth to the futures contract. Essentially, the seller of a futures contract would agree to sell a fixed quantity of a certain commodity on a particular day in the future to whomever wanted to buy the contract. The price of this contract would depend on the demand from buyers, as well as the supply from other sellers.

In a similar way, the buyer of the futures contract would agree on a fixed price to buy the underlying commodity from the seller on the expiration date of the contract. For instance, with Admiral Markets you can trade CFDs on commodities and other similar products. Nowadays, when trading futures there are more than just commodities available (which we will explain in further detail later in this article). However, the pricing has remained in the same locations, such as the big futures exchanges in America.

A few of them include:

  • The Chicago Mercantile Exchange
  • The Chicago Board of Trade
  • The New York Mercantile Exchange

Futures exchanges can also be found across Europe and in other major financial trading hubs. The only difference now is that instead of people buying and selling contracts in the ‘pit’, it’s all performed electronically through a broker.

What is Futures Trading?

So far we’ve mentioned who the futures market was designed for – businesses, farmers, miners and so on. However, because of the often extreme price movements in some of these markets, it has also given birth to speculators and different styles of futures trading. One such style is day trading futures. In this type of trading, a trader would speculate on short term price movements throughout the trading day. Most day traders are highly active, often taking multiple positions a day to seek out a profit at the end. However, it is considered very risky to start out this way, especially for beginner traders.

Another style of trading is futures spread trading. The foundation of this style is to profit from the change in the price of two different positions. For example, a futures spread trader could take two positions at the same time, on the same market, but with different dates to try and profit from the price change. Some traders may elect to use longer term strategies, but as you go on to learn about futures trading contract sizes, it really is for those with very large sums of capital. Let’s take a look at how these futures contracts are actually traded:

Trading Futures Contracts

So far, we know that a futures contract is an agreement by one party to buy, or take delivery, of a product like a commodity or a currency, at a fixed future date and price. But how are they actually traded? Futures are traded on exchanges where all contracts are standardised. This basically means that each contract has the same specification, no matter who is buying or selling. Contracts are typically standardised in terms of quality, quantity, and settlement dates.

For example, everyone trading an oil contract on the New York Mercantile Exchange knows that one contract will consist of 1,000 barrels of the West Texas Intermediate (WTI) oil at a particular quality level. Most futures contracts come in five character codes. The first two characters identify the product, the third identifies the month, and the last two identify the year. For example, WTI oil could read CLX20. CL = Crude Oil, X = November (there is a certain code of months and letters listed on the exchange’s website) and 20 = Year 2020.

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Of course, there are some disadvantages to having a fixed expiry date of your position (as we highlight further down in this article). Also, you cannot change the size of the contract, which can often be quite large. In the example of oil one contract is the equivalent to 1,000 barrels of oil. You cannot trade in less. As some futures contract sizes can be quite large, some of those involved in futures spread trading and day trading futures have turned to CFD trading.

What are CFDs and CFD Trading?

A CFD is a derivative product that allows a trader to speculate on the rise and fall of a market. They were originally developed in the early 1990s in London by two investment bankers at UBS Warburg. Essentially, a CFD is a contract between two parties, the buyer and the seller. It stipulates that the seller will pay the buyer the difference between the current value of a market, and the value when the contract ends.

In this instance, the seller is usually your broker, unlike futures trading where you trade directly with an actual buyer or seller of the commodity you are trading. With a CFD, the trader pays the difference between the opening and closing price of the underlying market. Whilst CFD trading may seem similar to futures trading, there are some big differences.

What is the difference between futures and options?

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Futures and Options are types of derivatives. Derivatives derive their value from an underlying instrument like a stock, commodity, currency etc. The basic difference between Futures and Options is in the obligations bound on the buyers and sellers.

In Futures, both, buyers and sellers have an obligation to execute the contract on a specified date whereas in Options, the buyer has the right but not the obligation to execute the contract. Only the seller has the obligation to execute the contract.

The other difference between Futures and Options is in the limit of profit and loss for a buyer. A buyer in Futures market can make unlimited profit and loss. In the Options market, a buyer can make an unlimited profit but limited loss.

Futures vs. Options – Which Should You Trade?

Futures and options are both financial derivatives traded by institutions and individuals, either to turn a profit or to hedge against current investments. Some traders like to trade both, while some have a preference for one over the other. When you weigh up your own trading choices between futures vs. options, you must understand the pros and cons of each.

That’s where we come in. In this guide, we’ll deep-dive into the features of futures and options contracts, take a look at how they originated and how today’s traders across different markets use them. We’ll also compare the opportunities and risks of both stock futures trading and options contracts and examine the current state of the crypto-derivatives markets.

What is a Futures Contract?

When you hear the terms “futures” and “futures contract,” they mean one and the same thing. A futures contract is a simple legal agreement between two parties that a particular asset or commodity will be sold at a pre-agreed price on a specific date in the future.

Futures are one of the oldest forms of derivatives, and their origins offer a simple way of explaining how futures work. Futures emerged as a means of farmers hedging against the future value of their crops. At the start of the growing season, the farmers couldn’t predict whether or not they would have a good or a bad harvest, as it would depend on factors such as the weather.

Similarly, imagine a baker buying the wheat from the farmer on the other side of the transaction – they were subject to the same uncertainty. So, the farmers and the bakers would agree on a price for the harvest at the start of the season.

According to the laws of supply and demand, a good harvest would increase supply, and push down the price of the wheat. Conversely, a poor harvest creates a shortage, driving demand, and wheat prices high. By entering into a futures contract, the farmers and the bakers could hedge their overall risk by agreeing on the harvest price upfront.

Although the markets have evolved, the nature of futures contracts remains the same. Today’s futures markets consist of hedgers and speculators. Hedgers are the parties with commodities or assets to sell who want to secure an agreed price. Speculators are those trade futures contracts against the value of the asset without ever planning to take custody of the asset itself.

The financial markets are filled with jargon, so you may come across different terms and be left wondering “what are stock futures?” or “what are forex futures?” Rest assured that the explainer given here applies to any futures market, whether the underlying asset is stocks, fiat currencies, cryptocurrencies, or commodities like oil, metals, or utilities.

So now that you’ve had a futures contract explained, how does an options contract work?

What is an Options Contract?

A critical difference between futures and options is that an options contract doesn’t represent a legal agreement to buy or sell. An options contract creates a right, not an obligation, to enter into a trade before a fixed date at which the contract expires.

Options contracts are of two types. A call option is a contract that allows the trader to buy a particular asset at a fixed price, called the strike price before the contract expires. Let’s say someone opens a call option to buy BTC at $10k with an expiry date at the end of 2020.

If BTC goes up to $15k, the trader can buy the BTC at $10k and immediately sell on the open market at $15k, realizing a $5k profit on the transaction. They could also sell the option contract itself, as it already represents a profit.

The other type of option is a put option, which works in exactly the same way except it represents a sell transaction rather than a buy transaction.

Like futures contracts, options contracts have a long and rich history, stretching all the way back to Ancient Greece . Aristotle provides a great example of options contracts in action at the time. He wrote of a poor philosopher called Thales, who made his wealth by forecasting the future year’s olive harvest.

Thales made agreements with the olive press owners for the option to use their olive presses at a fixed value. The next year, there was a bountiful olive harvest. Due to the increased demand for olive presses, Thales was able to sell his “olive press options” for a profit.

What is the Difference Between Futures and Options?

So, now we’ve covered the difference between futures and options on a mechanical level, what are the differences between future and options in a trading scenario?

Buying options offer a more conservative approach to trading. When buying options, the trader can never lose more than their initial investment, known as the premium. The premium value may vary depending on the difference between the option strike price and the actual asset price and the time left before the option expiry.

Regardless of whether the asset price falls way below the premium, the trader doesn’t lose any more than this value. This applies if they can’t sell the option and choose not to exercise their right to buy.

The option seller faces far more risk, as they must honor the agreement to sell the options at the strike price. Selling (also called writing) options can lead to very high losses in volatile markets and are best left to the most experienced institutional options traders.

Futures represent a legally binding agreement to buy an asset; therefore, they carry more risk as the trader cannot simply choose not to fulfill the trade. Furthermore, profits and losses are directly linked to the value of the asset with no premium to offset the downside.

Conversely, though, trading futures offers the opportunity for far higher returns than trading options. Trading futures on margin amplifies the potential for even bigger profits, and losses, with futures trading.

Options trading can be more complicated to understand than futures trading. However, once the basics are in place, options represent a solid choice for a newer trader. Because the risk exposure on a call option is limited to the premium paid, a trader can get away with understanding less about the market itself.

On the other hand, experienced traders who know their markets well tend to opt for futures vs. options. If you’ve spent long enough understanding the markets for a particular asset, then you’re more likely to turn a bigger profit using leveraged futures contracts than with options.

Markets for Futures and Options

You can trade futures and options across a wide variety of markets. These include:

  • Stocks such as Apple, Google or any publicly-traded company
  • Indices such as the S&P 500 or the DJI
  • Foreign currencies
  • Commodities such as precious metals, oil, and gas, or agricultural products
  • Cryptocurrencies such as Bitcoin or Ether

Trading in these markets can happen both over-the-counter and in exchanges.

In the traditional financial markets, there is an even broader range of financial derivatives, including forwards and swaps covering a variety of assets. However, in the cryptocurrency space, it’s the futures contract that currently reigns supreme.

The Burgeoning Crypto-Derivative Market

A vast market for cryptocurrency derivatives has emerged over the last year or two. BitMEX first opened its doors in 2020, but the CME and the Cboe started offering bitcoin futures contracts to institutional clients in December 2020. The primary attraction in trading cryptocurrency derivatives is that the markets are more volatile. This volatility provides the opportunity for traders to realize far more significant gains than in traditional markets, which are more stable. Futures trading also provided the first means of going short on bitcoin.

At this point in 2020, there are more exchanges to choose from if you want to trade cryptocurrency futures. BitMEX still dominates, but there are plenty of other choices, including Deribit, Bybit, and Cryptofacilities. Many existing cryptocurrency exchanges have expanded into futures too, including OKEx, Huobi and soon, Binance.

Once Digitex launches, we aim for our zero-commission, decentralized futures exchange to outrank each of them on factors including fees, leverage, security, and liquidity. With the crypto futures markets at an all-time high , there’s no better time than now for new entrants to emerge.

At the time of writing, the only exchange offering cryptocurrency options is Deribit. This makes the market for options far more limited than futures.

At Digitex, we firmly believe that futures are the superior choice, particularly for more experienced and regular cryptocurrency traders. They were the first crypto-derivative to emerge, they provide the opportunity for the highest returns, and they have strong institutional and retail support. While the prospects for cryptocurrency options trading remain limited, liquidity will continue to be a challenge. Of course, things could change if more exchanges start offering options.

Knowledge is Power

So, what about newcomers to the markets, or those who don’t trade so regularly? Well, there are no barriers to entry. However, newcomers to all kinds of trading should take steps to ensure they are educating themselves about the futures trading basics, such as types of instruments on offer and the markets for the underlying assets.

It will also help to gain an understanding of the principles of technical and fundamental analysis which traders use to read and forecast market fluctuations. Furthermore, all traders, whether newcomers or the most experienced, should have an understanding of their own appetite for risk, and know when to exit a losing trade.

Following these principles will serve you well, whether you choose to trade spot or derivatives, crypto or stocks, want to make a living trading futures or just trade for fun on the side, or engage in day trading or long term investing. If you want to learn more, the Digitex blog is a great place to start. We’ve published many informational articles which explain futures trading in-depth, covering jargon, strategy, analysis, trading versus investing, and much more. In trading as in life, knowledge is power.

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