Posted By: Ilan Levy-Mayer Vice President, Cannon Trading Futures Blog
Futures Trading vs Options: What’s the Difference?
Written by Mark O’Brien, Senior Broker
The answer to this piece’s title question is: there are quite a few differences between futures and futures options. Let’s get right to it. There are two types of options – call options and put options. Their risks and opportunity potential differ depending on whether you’re analyzing purchased / long calls and puts or sold / short calls and puts. So, we’re really comparing futures with four different types of options: long call options, short call options, long put options and short put options. If you’re already chafing at the confusion you see coming, hold steady and we’ll try to clear things up.
The easiest starting point is to look first at the risks and opportunities in trading a straight futures contract. This is so because there are only two positions you can take in a futures contract. You can buy a futures contract, often termed “going long,” or you can sell a futures contract, described as “going short.” Regardless of whether you’re long or short a futures contract, the risk of loss and the opportunity for profit is equally measureable by the price change in that futures contract. If each single price change in a futures contract – called a tick – is equal to $10, then a 10-tick move up and a 10-tick move down are both equal to a $100 move. The result of a 10-tick move up for a long futures contract would be a gain of $100. The result of a 10-tick move down for a long futures contract would be a loss of $100. Conversely, the result of a 10-tick move down for a short futures contract would be a gain of $100. The result of a 10-tick move up for a short futures contract would be a loss of $100. So, whether you’re long or short a futures contract, you’re risk and opportunity potentials are the same.
Probably one of the more imposing aspects of trading straight futures contracts – at least at first – is that there are about fifty different principal futures contracts available for trading – in categories such as metals, grains, currencies, energies, livestock and more – and their tick values can differ. Each tick in the British Pound is equal to $6.25; each tick in Unleaded Gas is $4.20; each tick in Coffee is $3.75; each tick in Gold is $10. Further, some futures contracts’ minimum incremental price moves can be more than one tick at a time. The minimum price move for Sugar is one tick; the minimum price move for Copper is five ticks; the minimum price move for Live Cattle is 2 ½ ticks. How confounding is that?
Yet, like any new information you’re attempting to stockpile in your brain – especially when your trading account’s money is at stake, with exposure comes familiarity. So, whether you’re actively taking positions in dozens of markets each day, or concentrating your trading on one or two sectors or even one or two markets, you’ll want to become familiar with the contract specifications of what you’re trading.
If you’re looking to trade options, you have more homework. The first important distinction between futures contracts and futures options lies in their risks and opportunities. Remember, whether you’re long or short a futures contract, you’re risk and opportunity potentials are the same. Not so with futures options. The risks and opportunities are very different depending on whether you’re the option buyer (long) or the option seller (short).
In terms of risk, for the option buyer, the loss risk is limited to the purchase price of the option. So, if the price of the option loses value, it can only lose all its value – no more than that. On the opportunity side of the ledger, purchased options can increase in value based on the underlying asset it might eventually become if it was exercised. A purchased (long) call option will increase in value if its underlying asset (a long position in the market) increases in value. A purchased (long) put option will increase in value if its underlying asset (a short position in the market) decreases in value.
For the option seller, the risk/opportunity parameters are flipped. The limited loss assumed by the option buyer is also the limited opportunity afforded the option seller. The amount received in the sale of the option is as much as the option seller can ultimately collect. Conversely, sold options can increase in value based on the underlying asset it might eventually become if it was exercised. A sold (short) call option will increase in value if its underlying asset (a long position in the market) increases in value. A sold (short) put option will increase in value if its underlying asset (a short position in the market) decreases in value.
To encapsulate, the risk to purchased (long) options – both call options and put options – is limited to their purchase price. Their opportunities lie in the degree to which the underlying assets move favorably, that they could be converted to if they were exercised. The opportunity for sold (short) options – both call and put options – is the original price at which they are sold – the amount of premium – collected at the sale. Their risks lie in the degree to which the underlying assets move unfavorably and that they could be converted to if they were exercised.
This brings up another important power given to the option buyer not given to the option seller. The option buyer has the right to exercise the option and convert it to a position in its underlying asset. The option seller, on the other hand, is at the whim of the option buyer to see their option converted to a position in the market. So, only the option buyer can – if they wish – exercise their option and convert it to a futures contract
All these risks and opportunities come with two universal components that influence the value of every option: 1.) the option’s strike price and 2.) time. All options have a strike price. An option’s strike price represents the price to which the option is tied if it’s ever exercised and becomes a futures contract. A call option’s strike price is equal to the price at which a long position in the underlying futures contract is taken if the call option is exercised. A put option’s strike price is equal to the price at which a short position in the underlying futures contract is taken if the put option is exercised.
All options – no matter when they are purchased or sold – have lifespans. They all have expiration dates. And during their lifespans up until their expiration dates, their underlying assets are constantly changing price – fluctuations up and down, moving toward and away from strike prices up and down the market’s price range. Options whose expiration dates lie in the far distant future possess greater amounts of time with which to witness the underlying futures contract trade and potentially move toward its strike price or away from it. For this reason, they are valued more highly than those with closer-in-time expiration dates. So, as the saying goes, “time is money,” the term “time value,” is used to describe that part of an option’s overall value as it relates to the option’s expiration date. The farther away the option’s expiration date, the more time value is possesses.
The rules vary among exchanges that trade options, but generally an option buyer, if they ever choose to do so, can exercise their option at any time during the option’s lifespan – right up to its expiration date – and convert it to a position in the underlying futures contract. Conversely, the exercise of the long option causes a short option holder – an option seller – to be “assigned” the opposite position in the underlying futures contract.
At an option’s expiration date, a new set of rules comes into play. This is the date when – depending on the price of the underlying asset – an option is either “in the money,” or “at the money,” or it’s “out of the money.” If it’s a call option, it’s at or in the money if at expiration the underlying futures contract is trading at or above its strike price. If it’s a put option, it’s in the money if the underlying futures contract is trading at or below its strike price. This is the point in time and price when all options in or at the money are automatically converted and become positions in the underlying futures contract. All out-of-the-money options are not converted and become nothing. They expire worthless.
When you combine the selection of option strike prices up and down an underlying futures contract’s price range, with a range of expiration dates from nearby in time to far out, then offer long call options, short call options, long put options and short put options, the range of risk and opportunity in trading futures options is literally limitless. Never mind the added range of risk and opportunity available when trading any combination of futures options, or a combination of futures options and futures contracts (a discussion for a future article).