What Are Options and Futures? Key Differences Explained

Financial markets use various instruments to manage exposure to asset price fluctuations. Among these are derivatives, financial contracts whose value is directly linked to an underlying asset like a stock, commodity, currency, or index. These agreements allow participants to engage with market movements without necessarily owning the underlying asset itself.

What Are Options?

An option is a financial contract giving the buyer the choice, but not the obligation, to purchase or sell an underlying asset at a predetermined price on or before a specified date. This right is acquired by paying a fee, known as a premium, to the seller. An option’s value is directly connected to the price movements of its underlying asset, which can include stocks, bonds, commodities, currencies, or market indices.

Core components of an options contract include the underlying asset, the specific security or commodity the option is based on. The strike price is the fixed price at which the underlying asset can be bought or sold if the option is exercised. An expiration date sets the deadline by which the option must be exercised; after this date, the contract typically becomes worthless. The premium is the upfront, non-refundable cost paid by the option buyer to the seller for this right, representing the maximum potential loss for the buyer.

Options are categorized into two types: call options and put options. A call option grants the buyer the right to purchase the underlying asset at the strike price by the expiration date. Buyers acquire call options when they anticipate an increase in the underlying asset’s price, aiming to profit from its upward movement. For example, if a stock is trading at $50, a call option with a $55 strike price allows the buyer to profit if the stock rises above $55.

Conversely, a put option provides the buyer the right to sell the underlying asset at the strike price on or before its expiration. Put options are bought when a buyer expects the underlying asset’s price to decline, allowing them to sell at a higher predetermined price than the falling market value. For instance, if a stock is trading at $50, a put option with a $45 strike price allows the buyer to sell at $45 even if the market price falls below that.

Options trading involves both buyers and sellers. When a buyer pays the premium, they acquire the right to exercise the contract. A call option buyer can purchase the underlying asset at the strike price if its market value rises, profiting from the difference. A put option buyer can sell the underlying asset at the strike price if the market value falls, securing a favorable sale. If the market price does not move favorably, the buyer can let the contract expire unexercised, limiting their loss to the premium paid.

The seller, or writer, receives the premium. In return, the seller assumes the obligation to fulfill the contract if the buyer exercises it. For a call option, the seller must deliver the underlying asset at the strike price, even if its market price is higher. For a put option, the seller must purchase the underlying asset at the strike price, even if its market price has fallen. This obligation means the seller’s potential risk can be unlimited, especially if they do not own the underlying asset.

At expiration, an option’s outcome depends on the relationship between the underlying asset’s market price and the strike price. An option is “in-the-money” (ITM) if exercising it would result in a profit (market price > strike for calls; market price < strike for puts). It is "at-the-money" (ATM) if the market price equals the strike price, having no immediate intrinsic value. An option is "out-of-the-money" (OTM) if exercising it would not be profitable (market price < strike for calls; market price > strike for puts). OTM options typically expire worthless, causing the buyer to lose the entire premium.

Most exchange-traded options contracts are standardized, commonly representing 100 shares of the underlying stock. This standardization facilitates trading on regulated exchanges, such as the Chicago Board Options Exchange (CBOE), which provide a centralized marketplace and oversight. Options can also be traded over-the-counter (OTC) through private agreements, though exchange-traded options generally offer greater transparency, liquidity, and regulatory protection.

What Are Futures?

A futures contract is a standardized legal agreement that obligates two parties to transact a specific underlying asset at a predetermined price on a specified future date. Unlike options, both the buyer and the seller of a futures contract are bound to fulfill the agreement. This underlying asset can be a commodity, such as oil or corn, a financial instrument like a stock index, or a currency.

Key terms for futures contracts include the underlying asset, the specific item to be bought or sold. The contract size specifies the standardized quantity of the underlying asset covered by a single contract; for example, a crude oil futures contract might represent 1,000 barrels. The delivery date, also known as the expiration date, is when the transaction is scheduled to be completed. The settlement price is the price at which the contract’s obligations are valued, particularly at the end of each trading day.

A distinctive feature of futures trading is margin, a good-faith deposit both buyers and sellers must maintain with their broker to cover potential losses and ensure contractual obligations are met. There are two types: initial margin and maintenance margin. The initial margin is the amount required to open a new futures position, typically 3% to 12% of the total contract value.

The maintenance margin is a lower amount, representing the minimum equity to keep the position open. If the account falls below this level, a margin call is triggered, requiring additional funds to bring the account back to the initial margin level. This system ensures sufficient collateral.

The daily settlement process, known as “marking to market,” is another fundamental aspect of futures contracts. At the end of each trading day, open futures positions are revalued based on the current settlement price. Any gains or losses from the day’s price movements are credited to or debited from the trader’s margin account. This daily adjustment means that profits and losses are realized continuously, rather than only at the contract’s expiration. This mechanism reduces counterparty risk by preventing large accumulations of unrealized losses.

Futures contracts specify the quantity and quality of the underlying asset, making them highly standardized. This standardization enables efficient trading on regulated futures exchanges, such as the CME Group, which sets rules for contract specifications and settlement procedures.

Upon the delivery date, futures contracts are settled in one of two ways: physical delivery or cash settlement. Physical delivery involves the actual exchange of the underlying asset, common for commodities like agricultural products or metals. Many futures contracts, especially those based on financial instruments like stock indices, are settled via cash. In cash settlement, parties exchange the net cash difference between the contract price and the market price at expiration, without physical transfer. Cash settlement is often preferred for convenience and to avoid logistical complexities.

Comparing Options and Futures

Options and futures are both financial derivatives, with values derived from an underlying asset. Both are standardized contracts often traded on exchanges and have defined expiration dates. However, fundamental differences exist in their structure, obligations, and capital requirements.

The most significant distinction lies in the obligation they impose. An options contract grants the buyer the right, but not the obligation, to buy or sell the underlying asset. This flexibility means an option buyer can choose to exercise the contract only if it is financially advantageous, or let it expire worthless, limiting their loss to the premium paid. In contrast, a futures contract creates a binding obligation for both the buyer and the seller to complete the transaction at the agreed-upon price on the specified future date.

Regarding initial capital, options require the buyer to pay an upfront premium to the seller. This premium is the maximum amount the option buyer can lose. Futures contracts, on the other hand, do not involve an upfront premium payment. Instead, both parties are required to deposit and maintain a margin, which acts as a performance bond. This margin system, coupled with daily marking to market, means that gains and losses are settled daily, and potential losses for futures participants are theoretically unlimited as the contract value can move significantly against their position.

The inherent flexibility of options allows the buyer to walk away from the contract if the market moves unfavorably, forfeiting only the premium. Futures contracts, however, must be settled, either through physical delivery or cash settlement, unless the position is closed out before expiration. This means futures traders are exposed to the full price movement of the underlying asset from the moment the contract is opened.