Futures and options trading are two of the best known derivatives used on the financial markets today. But each of them have their own peculiar set of characteristics, which must be clearly understood before an aspiring trader risks precious funds on them.
If we were to highlight the essential difference, conceptually speaking, between a futures and options trading contract, we would explain it this way:- An option contract gives the buyer the right but NOT the obligation, to purchase an underlying asset at an agreed price, up to an agreed expiration date. A futures contract on the other hand, creates only an obligation to make, or take, delivery of the underlying asset at an agreed future date.
So let's see how futures and options trading works in practice.
How an Options Contract Works
Imagine you're about to buy an options contract for an underlying stock. The current market price of the shares is $30 and you believe it could rise to $35 within the next month. So you purchase an at-the-money $30 call option with an expiration date two months away. This gives you the right, but not the obligation, to "call" on the market to sell you the shares at $30 any time you choose to exercise it, up to the expiration date.
The price of the option contract is quite complex, but one of its main features is this thing called the "delta". The delta is the rate at which your option contract will increase or decrease in value in proportion to a change in the value of the underlying stock. For at-the-money contracts, the delta is usually 0.50 which means that for every dollar move in the underlying, the option contract changes by 50 cents. As the call option becomes further in-the-money, the delta increases to a maximum of 1, at which time it is changing dollar for dollar with the underlying.
If the option contract goes out-of-the-money, i.e. no intrinsic value, the delta decreases, leaving "time value" as the only component of the option contract. This "time value" is an expression in financial terms of the probability that the contract will be in-the-money by expiration date.
When you buy an option contact, the maximum amount you can ever lose is the amount you originally paid for the option premium. This is one reason they are so popular - the perceived limited risk.