Futures and options: what is the difference and how to choose the right instrument for investment

In the world of finance, there are many instruments for investing, among which futures and options occupy a special place. These instruments allow investors to capitalise on price fluctuations of various assets such as commodities, currencies, stocks and bonds. However, despite the fact that both instruments allow you to earn on price fluctuations, they have a number of significant differences. In this article, we will look at what these differences are and how to choose the right instrument for investment.

What are futures and options?

These are derivative financial instruments that allow investors to make money on changes in the prices of the underlying assets. However, despite their common purpose, these instruments have different mechanisms of operation.

Futures

These are contracts that commit the seller and buyer to a transaction to buy or sell an asset in the future at a predetermined price. This means that both parties undertake to fulfil the terms of the contract even if the market price of the asset changes.

Futures can be deliverable or settlement futures
A deliverable futures contract involves the actual transfer of a commodity (such as oil or gold) or financial instruments (such as stocks or bonds). However, most exchange-traded futures are nowadays settlement futures: these contracts are executed without the transfer of the asset itself, and the investor receives the difference in cash between the current market price of the asset and the price specified in the contract. Thus, the investor may make a profit or suffer a loss, but does not receive the asset itself. Certain futures, such as index or interest rate contracts, can exist solely in settlement form.

Here’s how you can visualise a futures contract using the dollar as an example:

Suppose the current price of a dollar is 96 ₽ and someone is willing to sell it in six months for 100 ₽. You believe the rate will rise even more, so you make a deal with another trader to buy $1,000 in six months at 100 ₽. If your bet pays off and the dollar rises to, say, 103 ₽, you will get the $1,000 at a better price than the market. However, if the price falls to 90 ₽ per dollar, you will still have to buy them for 100 ₽, resulting in a loss.

The example presented is a delivery contract. When settling a futures contract, each party gains or loses an amount equal to the difference between the contract price and the actual price.

Futures contracts are executed exclusively at the exchange, which is also responsible for their settlement. The terms of such contracts are standardised in terms of the underlying assets, their volume and quality, and the time of execution.

It should be noted that the parties cannot refuse to fulfil their obligations under futures contracts. However, if market conditions are unfavourable, the futures can be sold on the exchange.

When the buying and selling price of a futures contract coincide, the exchange concludes the contract and determines its price. It is on the basis of such transactions that the current futures price is formed. This is similar to the process of securities trading, where the exchange price is also set during trading.

It is important to realise that futures are not securities like stocks or bonds. They are not issued, and in fact traders create futures contracts by placing buy or sell orders with a specified price of the underlying asset at the time of execution, which is essentially a price forecast.

How much money will be required to trade futures

The amount of deposit you will need to trade futures depends on several factors:

1. Выбор биржи и инструмента. Разные биржи и инструменты предъявляют разные требования к размеру залога (CS) — сумме, которую необходимо внести на счет для открытия позиции. Маржа может быть выражена в процентах от стоимости контракта или в виде фиксированной суммы.
2. Требования к марже. Требования к марже — это процент от стоимости контракта, который необходимо внести на счет при открытии позиции. Требования к марже могут различаться в зависимости от биржи, инструмента и типа контракта.
3. Размер контракта. Размер контракта — это сумма, на которую заключается контракт. Размер контракта может варьироваться в зависимости от инструмента и биржи.
4. Кредитное плечо. Кредитное плечо — это соотношение между размером позиции и размером депозита. Чем больше кредитное плечо, тем меньше денег потребуется для открытия позиции, но и риски будут выше.
5. Стоимость контракта. Стоимость контракта — это сумма, которая будет получена или выплачена при исполнении контракта. Стоимость контракта может варьироваться в зависимости от цены базового актива и срока действия контракта.
6. Комиссии. Комиссии — это сборы за совершение сделок на бирже. Комиссии могут быть фиксированными или зависеть от размера сделки.

On average, a deposit of between $1,500 and $4,000 will be required to trade futures on the exchange. However, these are only rough estimates, and the exact size of the deposit will depend on all of the above factors.

It is also important to note

Futures, being an obligation to carry out a transaction in the future, has no value in itself. At the stage of ‘buying’ or ‘selling’ a futures, no payments are made by its parties. When one speaks of the price of a futures contract, it is the value of the future fulfilment of the contract, not the current price.

However, for such transactions, the investor will need funds because the exchange requires collateral to guarantee the fulfilment of the contract. For this purpose, the broker freezes about 10% of the futures value in the account. The amount of the margin is determined by the exchange and its data is published for each contract.

The margin remains locked until the position is closed and is recalculated by the exchange on a daily basis, which may cause it to increase or decrease depending on fluctuations in the futures price. Investors must ensure that there are sufficient funds in the account to maintain collateral for open positions.

Futures contracts can be traded until the date of fulfilment and can generate a profit or loss even without additional transactions. The exchange clears twice a day, when the contract price is fixed and the variation margin is calculated. If the price of the underlying asset falls, futures owners incur losses. The broker may close the position if there are insufficient funds for collateral.

Options

These are contracts that give the seller or buyer the right, but not the obligation, to enter into a transaction to buy or sell an asset in the future. This means that if the market price of the asset changes in the seller’s or buyer’s favour, they can exercise their right and make money from it.

However, an option differs from futures in that the obligations of the transaction are placed solely on one of the participants – the seller of the option.

That is, if you have sold an option to deliver shares, you will be obliged to sell them to the buyer at the price specified in the contract. However, the buyer is under no obligation to purchase those shares.

To balance the risks and rewards of the parties, options include a premium for the seller. The buyer can withdraw from the contract if the terms are unfavourable to him, while the seller has no such option.

Thus, the seller is in a less favourable position because his risks are significantly higher: while the buyer loses only the premium paid, the seller’s risks are the difference between the contract price and the market price at the time of exercise, and they are unlimited.

There are several types of options.

The most common option on the market is the call option, or call option. It is purchased in order to profit from the growth of the asset price in the future.

According to the terms of the call option, the investor can purchase securities at a set price in the future, but has the right to cancel the transaction if the conditions are unfavourable.

Here is an example

An investor decides to capitalise on an increase in AAA’s share price, but instead of buying the shares themselves, he enters into an option agreement. Six months from now, he intends to buy 1,000 shares of AAA stock at the current price of 1,050 ₽. For this right, he pays the seller a premium of, for example, 10,000 ₽. If the stock price rises to 1070 ₽, this contract becomes profitable. The investor will be able to buy the stock at 1,050 ₽ and then sell it in the market for 1,070 ₽, capitalising on the increase in price. The difference between the sale and purchase price will be (1070 – 1050) x 1000 = 20,000 ₽. The net profit will be: 20,000 – 10,000 = 10,000 ₽ (excluding commission). However, if the price falls to 1045 ₽, the contract will not be profitable as the stock is cheaper in the market. In this case, the investor will refuse to honour the contract and the seller will be left with the premium received (10,000 ₽).

Next, we will explain what the premium is and how it is written off.

A put option is a type of contract that gives an investor the right to sell their assets at a predetermined price. It is usually purchased in order to profit from an expected future price decline.

Suppose an investor anticipates that the value of AAA shares will decrease in six months, so he signs an option contract under which he can realise 1,000 shares at the current price of 1,050 ₽ 1050 ₽ in six months. If after six months the share price rises to 1,070 ₽, this contract will become unprofitable because the investor will be able to sell his shares at a higher price on the open market. Otherwise, if the share price falls to 1020 ₽, under the contract signed, the investor will be able to realise the shares at a higher price.

Options are most often purchased to protect against potential losses associated with real assets. For example, a put option on a stock helps insure a portfolio against falling prices. Put and call options have different premiums and are traded separately.

The most common options are those based on futures contracts. When buying such an option, the investor does not receive the underlying asset itself – stocks, bonds, etc. – but a futures contract on that asset, which can be either sold or waited for to be exercised.

Options based on futures are called futures-type options or margined options. Margin options are mainly traded on the Derivatives Section of the Moscow Exchange, and the settlement process for them is similar to that for futures contracts using variation margin.

How much money you need to trade options

The amount of money needed to trade options depends on several factors:

1. The size of your capital. The more money you have, the more options you can purchase. However, this does not mean that you need to invest all your money at once. It is recommended that you start with a small amount and gradually increase it as you gain experience and confidence in your strategies.
2. The type of options you want to trade. There are different types of options such as call, put, binary and others. Each type has its own characteristics and initial capital requirements. For example, trading binary options usually requires a small amount of money, but this can quickly increase due to the high risk involved.
3. The strategy you are using. Different strategies require different levels of capital. For example, trend trading may require more capital than news-based trading.
4. The risk you are willing to take. The more money you are willing to lose, the more options you can purchase. However, it is worth remembering that options trading involves risk and you may lose some or all of your funds.
5. Commissions and other charges. Options trading may incur commissions and other costs, which you should also take into account when calculating the capital required.

In any case, it is advisable to learn the basics and develop a strategy that suits your goals and capabilities before trading options.

It is also important to note

The value of an option contract is the premium that the buyer must pay to the seller of the option, regardless of whether the contract is exercised. This amount is the loss that the buyer will incur if the contract is not exercised. For the seller, the premium becomes a guaranteed income and its value is set in the course of trading on the exchange.

With a standard option, the buyer immediately pays the premium to the seller and no additional collateral is required; the guarantee is reserved only with the seller.

In the case of a margined option, the premium is not deducted from the buyer at the time of the transaction, but gradually through a variation margin mechanism, which is similar to futures settlement. Therefore, the broker also requires the reservation of collateral from the buyer before the contract is finalised or the option is sold.

The exchange calculates variation margin twice a day based on the transaction price and the settlement price of the option. If the settlement price is higher than the transaction price, the investor makes a profit and is charged margin; if it is lower, a loss occurs and the margin is written off. On the day the option is exercised through margin, the buyer eventually pays the seller the full amount of the premium.

The investor should keep a close eye on changes in the amount of the collateral, as it depends on fluctuations in market prices.

Main differences between futures and options

1. Obligations or rights. The main difference is that futures obligate both parties to fulfil the terms of the contract, while options give the right, but do not obligate the seller or buyer to complete the transaction.
2. Risks and Rewards. Because futures obligate both parties to fulfil the terms of the contract, the risks and rewards to both parties may be higher than with options. However, on the other hand, futures can provide a more predictable outcome because both parties know in advance what conditions will be met.
3. Expiration Date. Futures contracts have a specific expiry date after which they close. Options, on the other hand, can have different expiry dates, depending on the terms of the contract.
4. Exercise price. Futures contracts usually have a fixed strike price, which is pre-determined in the contract. Options can have different strike prices, depending on the terms of the contract.
5. Volatility. Futures contracts can be more volatile because both parties are obligated to fulfil the terms of the contract even if the market price of the asset changes. Options can be less volatile because the seller or buyer can exercise their right but is not obligated to do so.
6. Complexity. Futures contracts can be more complex to understand and use because they obligate both parties to fulfil the terms of the contract. Options can be simpler to understand and use because they give the right, but do not obligate the seller or buyer to complete the transaction.
7. Contract Price. Futures contracts usually have a higher contract price because both parties are obligated to fulfil the terms of the contract. Options may have a lower contract price because the seller or buyer can exercise their right but is not obligated to do so.
8. Liquidity. Futures contracts may have higher liquidity because they obligate both parties to fulfil the terms of the contract. However, options may have lower liquidity because the seller or buyer may not exercise their right.

How to choose the right investment instrument?

The choice between futures and options depends on several factors such as investment objectives, risk level, expected returns and others. Let’s consider some of them:

1. Investment Objectives. If your goal is to make money from fluctuations in asset prices, futures may be a more suitable instrument, as they oblige both parties to fulfil the terms of the contract. If, on the other hand, you want to make money on asset price changes but don’t want to make a commitment, then options may be a more appropriate instrument.
2. Risk level. Futures can be riskier because they commit both parties to fulfil the terms of the contract, even if the market prices of the asset change. Options may be less risky because the seller or buyer can exercise their right but is not obligated to do so.
3. Expected returns. Futures can provide a more predictable outcome because both parties know in advance what conditions will be met. Options can provide a higher return because the seller or buyer can capitalise on changes in asset prices.
4. Liquidity. Futures contracts can have higher liquidity because they obligate both parties to fulfil the terms of the contract. Options may have lower liquidity because the seller or buyer may not exercise their right.
5. Expiration Date. Futures contracts usually have a specific expiry date after which they close. Options may have different expiry dates, depending on the terms of the contract.
6. Complexity. Futures contracts can be more complex to understand and use because they obligate both parties to fulfil the terms of the contract. Options may be simpler to understand and use because they give the right, but do not obligate the seller or buyer to complete the transaction.
7. Other factors. Other factors such as tax implications, availability of instruments in the market and others can also be considered when choosing between futures and options.

In conclusion, the choice between futures and options depends on many factors such as investment objectives, risk level, expected returns and others. It is advisable to consult a financial advisor or investment specialist before deciding on the choice of an investment instrument.