Futures and options trading can be a risky business indeed and should only be undertaken with risk capital that won’t change your lifestyle if you should lose your investment. The potential for profits is almost unlimited while the potential for loss is almost equally unlimited. This means that if you are on the losing end of a naked futures trade you can stand to lose more money than you have in margin and you are responsible for the entire contract amount because of the highly leveraged nature of the investment. There are many ways to limit your risk and one of these is to use options as a hedge against a negative price movement away from your position whether it is on the long side or on the short side. Lets take a look at some of the differences between futures and options trading.
While I said that there is almost unlimited downside potential this is basically only true for an option if you sell that option without holding an opposite position. So if you were to sell a June 900 put gold option and the market went to 800 you are responsible for the 100 points that the gold contract has gone against your position. Your loss would be the difference minus the premium you collected for selling the gold put. Because of the volatile nature of the markets you should figure in how much you are willing to risk on any one trade and then open an opposite position to minimize your downside risk. This can be done with both futures and options trading.
Differences between futures and options trading
1. Premium vs margin
Options: When you buy an option you are not required to put up any margin because you are purchasing the option at a fixed price, which is also referred to as the premium. This premium can decline over the life of the option if the underlying commodity price moves against your position or remains flat. If the option isn’t exercised before expiration you will lose the premium you paid and the seller of the option will profit the amount of the premium paid.
Futures: While the premium for a futures option will waste away with time the futures contract will not. You can think of the margin on a futures contract as earnest money that will make you liable for the full amount of the futures contract. This is very risky if an offsetting position is not opened to help protect you against a negative price move.
Options: As an options purchaser you are only limited to the amount of the premium that you paid for the option therefore your risk is considered to be limited.
Futures: Regardless of whether you purchase a futures contract or you sell a futures contract you are liable for more than just the initial margin you were required to put up to make the trade. This makes this type of trade risk unlimited.
3. Expiration Dates
One last notable difference between futures and options trading is the expiration date of each particular contract. If you were going to exercise an option to control the underlying futures contract you should know that this has to be delivered approximately one month before the underlying futures is set to be delivered. This is for physical delivery of the commodity and doesn’t hold true for the indices, which are not physical commodities and allows the expiration dates to be the same as the delivery dates.
As you can see there are several fundamental differences between futures and options trading with regards to technical aspects of each contract. Trading these instruments is a whole other matter in terms of trading platforms and specialized risk management techniques. Use this article as a basic primer for further studies on futures trading and see if futures and options trading are right for you.