Futures and options are both derivative instruments, which means they derive their value from an underlying asset or instrument. Both futures and options have their own advantages and disadvantages. One of the advantages of options is obvious.An option contract provides the contract buyer the right, but not the obligation, to buy or sell an asset or financial instrument at a fixed price on or before a predetermined future month. That meansthe maximum risk to the buyer of an option is limited to the premium paid.
But futures have some significant advantages over options.A futures contract is a binding agreement between a buyer and seller to buy or sell an asset or financial instrument at a fixed price at a predetermined future month. Though not for everyone, they are well suited to certain investments and certain types of investors.
Key Takeaways
- Futures and options are both commonly used derivatives contracts that both hedgers and speculators use on a variety of underlying securities.
- Futures have several advantages over options in the sense that they are often easier to understand and value, have greater margin use, and are often more liquid.
- Still, futures are themselves more complex than the underlying assets that they track. Be sure to understand all risks involved before trading futures.
1. Fruitful Investment
Futures may not be the best way to trade stocks, for instance, but they are a great way to trade specific investmentssuch ascommodities, currencies, and indexes. Their standardized features and very high levels of leverage make them particularly useful for the risk-tolerant retail investor. The high leverage allows those investors to participate in markets to which they might not have had access otherwise.
2. Fixed Upfront Trading Costs
The margin requirements for major commodity and currency futures are well-knownbecause they have been relatively unchanged for years. Margin requirements may be temporarily raised when an asset is particularly volatile, but in most cases, they are unchanged from one year to the next. Thismeans a trader knows in advance how much has to be put up as an initial margin.
On the other hand, the option premium paid by an option buyer can vary significantly, depending on the volatility of the underlying asset and broad market. The more volatile the underlying or the broad market, the higherthe premium paid by the option buyer.
3. No Time Decay
This is a substantial advantage of futures over options. Options are wasting assets, which means their value declines over time—a phenomenon known as time decay. Anumber of factorsinfluence the time decay of an option, one of the most important beingtime to expiration. An options trader has to pay attention to time decay because it can severely erode the profitability of an option position or turn a winning position into a losing one.
Futures, on the other hand, do not have to contend with time decay.
4. Liquidity
This is another major advantage of futures over options. Most futures markets are very deep and liquid, especially in the most commonly traded commodities, currencies, and indexes. This gives rise to narrow bid-ask spreads and reassures traders they can enter and exit positions when required.
Options, on the other hand, may not always have sufficient liquidity, especially for options that arewell away from the strike price or expire well into the future.
5. Straightforward Pricing
Futures pricing is intuitively easy to understand. Under the cost-of-carrypricing model, the futures price should be the same as the current spot price plusthe cost of carrying (or storing) the underlying asset until the maturity of the futures contract. If the spot and futures prices are out of alignment, arbitrage activity would occur and rectify the imbalance.
Option pricing, on the other hand, is generally based on the Black-Scholesmodel,which uses a number of inputs and is notoriously difficult for the average investor to understand.
Which Is Riskier, Futures or Options?
A lot can depend on your risk tolerance, but generally, futures are riskier than options. A futures contract is a binding agreement between a buyer and a seller to trade an asset at a fixed price at a predetermined future month, meaning the buyer and seller are locked in to the trade. That's inherently riskier than an option trade, in which a contract buyer has the right, but not the obligation to complete the trade. Additionally, with futures, even small shifts in the price of the underlying asset can have an impact on trading.
What Futures Are Most Commonly Traded?
The most frequently-traded types of futures are agricultural, energy, metal, currency, and financial.
Can You Buy Commodities Without Buying Futures or Options?
You can still buy or sell commodities without trading futures or options by purchasing commodity-heavy mutual funds or exchange-traded funds (ETFs). Any such funds would include stocks, futures, and derivatives contracts that track the movements of the underlying commodity.
The Bottom Line
While the advantages of options over futures are well-documented, the advantages of futures over options include their suitability for trading certain investments, fixed upfront trading costs, lack of time decay, liquidity, and easier pricing model.
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