Two of the most aggressive ways to invest in the stock market are by trading options and futures. Experienced investors may use these products to amplify their returns. However, a losing trade also a realistic possibility.
Are futures or options better? The answer depends on your investing goals.
Here’s what to know about investing in futures and options.
What are Options and Futures?
Options and futures are two ways for investors that make it easier to capture the potential price increases or decreases in stocks, commodities, futures and other investment assets.
Both of these investment products are riskier than stocks and bonds. Beginner investors and risk-averse inverse may prefer traditional investments like index funds or individual stocks.
What makes futures and options different than buying stock is they are a derivative. Investors buying stock options don’t have voting rights like owning equity stock shares.
Also, stocks or the actual commodity can be held indefinitely. But futures and options are traded as contracts with a specified expiration date.
Most contracts expire within several days, weeks or months. You may not have enough time for your investment theory to play out and you lose money by having to close the position early.
Investors can use these two products to hedge against potential price drops or earn an extra profit if they believe the underlying asset price will increase before the option or futures contract expires.
For example, you can buy Apple stock, have shareholder voting rights and make money if the share price increases. Options traders can buy a “call option” to earn more profit if the share price increases or a “put option” to profit if the share price drops but don’t get voting rights.
Why Trade Future and Options?
There are two primary reasons to trade options and futures.
Anticipate Higher Prices
The first strategy to trade these investment products is when investors expect higher share prices.
For example, investors can buy “calls” of a stock they believe will rise in value in the coming days, weeks or months. If the share price rises above the price the investor predicts, they make a profit.
Hedge Against Price Losses
Investors anticipating a price drop can buy “puts” that predict the share price will be below a specific price when the contract expires. If so, they make money even though people holding the stock equity with a long-term position are losing money.
People choose to bet against a stock or another asset to make money during a market correction. They may also do this to offset paper losses from their long-term positions.
How are Options and Futures Similar?
There are several similarities between futures and options:
- Both trade as derivatives
- Both have specific expiration dates
- Sell-type trades require a margin account
- Can make money from asset price increases or decreases
- Can be riskier than traditional investing strategies
- Neither product has voting rights or earns dividends
Both investment products can be an effective way to make a short-term profit even if you own the same underlying asset in your long-term portfolio.
For example, you may invest in an S&P 500 index fund that you will hold until retirement. But if you think the index will have a short-term correction, you might buy a put option that can earn money if the stock price drops.
What’s the Difference Between Options and Futures?
While there are many similarities between options and futures, there are several differences.
Upfront Financial Commitment
Options have a more significant upfront investment premium than futures. Buying options doesn’t require a margin account.
Selling options can require a margin account and having to make a higher initial investment than futures.
Futures can have a lower initial investment minimum than similar options contracts but require a margin account. The broker may require a “margin call” to increase the cash balance if the contract value declines too much.
Potential Investment Returns
Most options legs have limited downside risk and have unlimited profit potential. Investors lose the entire investment premium if the contract expires before the share price reaches the break-even price.
Futures can have unlimited gains or losses as the buyer and seller agree to sell a contract at the market price on the contract closing date. This trade also requires leverage and the broker may liquidate the contract early to raise funds if the maintenance account doesn’t have enough money to meet the margin call.
Investment Risk
Buying options can be less risky than trading futures because no margin account is necessary and the only potential losses are the investment premium.
Selling options requires a margin account which can amplify potential gains or losses depending on how the trade performs.
Futures are riskier because they use leverage and the total investment costs depend on the contract closing price.
Because of the extra volatility, futures can be better for short-term investing. Options may be better for longer-term trades as investors have more time for the share price to be “in the money” and earn a profit.
Another potential risk for futures is the delivery method of either cash or the physical commodity. Traders will need to make sure they trade cash-settled futures to pay some money for buying futures of assets like gold or crude oil instead of taking physical delivery.
Investment Options
Most online brokers only allow investors to trade options for individual stocks and exchange-traded funds. To trade options for gold, you would have to find a gold commodity ETF instead of the actual commodity price.
Futures are tradeable for basically any asset that trades on an exchange.
Some examples include:
- Stocks
- Stock indexes
- Bonds
- Commodities
- Currency
Investment Fees
The trade commissions can be lower for options than futures. Margin costs can also apply when making leveraged trades.
Trading Hours
Options mainly trade during standard stock market hours. That’s from 9:30 am to 4:00 pm Eastern for the US exchanges, Monday through Friday.
Select brokerages may also offer pre-market trading from 4:00 am to 9:30 am and after-hours from 4:00 pm to 8:00 pm. These hours were once only available to institutional investors like hedge funds.
Futures usually trade from 6:00 pm Sunday evening to 5:00 pm Eastern on Friday evening. There may be a short daily break but futures essentially trade “24/5” and take the weekends off.
Tax Treatment
Investment gains for options and futures in non-retirement brokerage accounts are taxable.
Gains from options are taxed as 100% ordinary income as they are a short-term gain. This tax treatment is similar to the wages earned from your day job or a side hustle.
Futures are taxed more favorably at 60% long-term capital gains and 40% short-term ordinary income.
Options Trading
This section takes an in-depth look at options and how they work.
Most investors may choose to invest in options instead of futures. They can be less risky and brokers are more likely to offer options than futures.
How Options Work
Here is a basic example of how options work.
Before we get into some examples, it’s important to know the different parts of an option:
- Option price: The price per options contract
- Expiration date: The date when the options contract expires
- Strike price: The minimum share price to exercise shares and make money
Most brokers require investors to trade at least 100 options contracts at a time. For example, if a single contract costs $0.50, the investment fees costs $50 to make a trade. It’s possible to lose the entire $50 if the contract expires before the trade becomes profitable.
Time Decay
One essential factor to pay attention to is “time decay.” Even profitable options trades may not earn as much money by closing the trade closer to the expiration date.
For example, you might buy a call option that makes money if the share price rises above a certain level. If the stock has a sharp daily price increase several days or weeks before the expiry date, closing the trade now means you make more money than if the stock is trading for the same price when the contract expires.
Futures contracts don’t experience time decay and you can earn the same amount of profit by closing futures trades at any point before the contract closes.
In the Money or Out of the Money?
There are three other terms that options traders must become familiar with:
- In the money: The share price is trading above the strike price
- At the money The share price is trading near the strike price
- Out of the money: The share price is trading below the strike price
Options must be “in the money” to be profitable. But investors must factor the contract fees and trade commissions as this premium erodes the total profit.
Trades that are “at the money” or “out of the money” when the option expires will be worthless and lose the investment amount.
Types of Options
There two primary types of options that investors can buy or sell. One doesn’t involve margin trading and the other does.
Call Option
A call option makes money when the share price increases above a certain price. Choose this option if you’re bullish and think the stock price will increase.
For example, a call option with a $50 strike price must have a share price trading above $50 to close for a profit.
Put Option
A put option makes money when the share price trades below the strike price. Choose this option if you’re bearish.
In this instance, a $50 strike price means the share price must be below $50 to profit.
Buy or Sell Options
In addition to deciding whether to trade call or put options, they must also decide whether to buy or sell.
Buying Options
Buying options can be less risky as it doesn’t require leverage. Your only investment premium is the upfront cost to buy the call or put contracts.
Selling Options
Selling options (also known as “writing” options) requires a margin account. United States law requires investors to have a minimum $2,000 margin account balance to make leveraged trades.
In addition to any upfront premium, brokerages charge margin interest. For out-of-the-money options, you may have to pay a difference to close the trade too.
Closing Options Contracts
Most contracts expire at the end of regular market hours on the contract expiration day. The brokerage will distribute any profits.
But, an investor may decide to close their position early if they are in the money and stand to earn a profit and don’t want to see their fortunes reverse at the last minute.
It’s possible to exercise options contracts early to take profits or minimize losses.
Are Stocks or Options Better?
Options are riskier than holding individual stocks and many contracts expire worthless because of the short-term investment period. Risk-averse inverse and long-term investors may be better off avoiding options.
One advantage of trading options is having to invest less money to get higher investment returns than buying whole shares of stock when you’re highly bullish (or bearish) on prices.
Options contracts are a fraction of the actual share cost but you can enjoy the advantages of the share price movement.
For example, buying a leverage-free call option contract may cost $20 per contract ($2,000 per 100 contracts) of a stock currently trading for $560. The call option expires in one month and you break even if the share price increases by 3% to $580 per share.
Let’s say the stock price increase to $585. The potential options profit from this trade would be $445 and higher if you can sell your option before the expiration date.
You can use an options calculator to estimate potential profits before making a trade.
Options can lose value the close they get to the expiration date because of a concept known as “time decay.” Closing your positions early to take profits early can be better if you’re “in the money.”
If you decide to invest the same amount of cash to buy the actual stock instead of the option, you have to spend $2,240 to buy 4 whole shares of the $560 stock. The four shares of stock will only profit $100 for the same price move if the share price rises $15.
Of course, if the option isn’t profitable, you lose all of the $2,000 investment. With the stock, you can at least hold longer to wait for the share price to increase. You can also see the stock at a loss to recoup some of the original investment.
How Futures Work
Futures are similar to options yet require a greater financial commitment. Investment costs are variable because the cost basis changes daily, making it harder to calculate the downside risk.
Futures can provide exposure than options to more alternative assets like the spot price of crops, precious metals and foreign currency.
Here are some investment terms for futures contracts:
- Initial margin: The minimum initial investment to open a contract
- Margin requirement: Minimum daily margin balance to keep the contract open
- Expiration date: When the contract expires
- Settlement method: Does the buyer receive cash or the physical asset?
Brokerages use the “mark to market” pricing practice that closes the contract daily. This practice requires the trader to add more margin if their investment is currently losing money.
If the contract is gaining in value, the investor won’t need to add to their margin balance.
Buy or Sell Futures?
Traders must predict if the futures contract will be higher or lower than the current market price.
Buy Futures
It can be better to buy a futures contract if you believe the asset price will be lower than the contract amount. If not, you will need to buy the asset for the opening contract price.
Sell Futures
Selling futures can be a better move for bullish investors thinking an asset price will increase from the opening contract price. This move is similar to shorting a stock.
Physical Delivery or Cash-Settled Futures?
Investors will also need to pay attention to how the sellers settles the trade. It’s possible the buyer may need to accept physical delivery of the commodity.
Physical Delivery
Futures that require a physical settlement require the seller to ship the asset to the buyer. Buyers must pay the closing contract price and accept delivery.
To prevent confusion, online brokers may require traders to close their physical-backed contracts before the contract expiration date as their platform doesn’t facilitate the delivery process.
Here are some ticker symbols of physically-settled futures:
- Corn (/ZC)
- Crude oil (/CL)
- Gold (/GC)
As you might expect, buyers can receive barrels of crude oil or bushels of corn when the contract closes.
Cash-Settled
Investors that don’t want the hassle of physical commodities can trade the cash-settled equivalents of the underlying asset.
Futures exchanges trade E-mini funds of commodities and stock market indexes.
Some examples include:
- E-mini S&P 500 (/ES)
- E-mini Nasdaq 100 (/NQ)
- Micro E-mini gold (/MGC)
- Micro E-mini Euro (/M6E)
Closing Futures Contracts
Ending a futures contract can be more difficult than an option. An option can expire worthless at the expiration date if the buyer doesn’t meet the strike price.
However, futures can require more monitoring to avoid taking delivery of physical-settled contracts.
Investors who originally bought a futures contract will need to sell a similar contract to cancel the order. The process is revered for people selling futures.
Brokerages offer a customer support line that can help futures traders navigate the closing process to avoid investing mistakes.
Are Stocks or Futures Better?
Trading futures can be a good way to earn outsized returns for traders that have a strong conviction for a bullish or bearish position. You must also be comfortable with using leverage.
Futures can be one way to get exposure to commodities and also trade stocks outside normal market hours. Also, futures contracts can require less upfront capital than buying whole stocks to get similar returns.
Traditional stock equities can be better for investors that don’t have the time or risk appetite to predict what future asset prices will be. You may not make as much money per successful trade but the downside risk is lower.
Summary
Options and futures can be an effective way to make a profit for short-term traders. But these strategies can require extensive investment experience. New investors and those who don’t want to trade with margin should consider long-term investing ideas instead.
If you’re looking for the best app for trading, please see our article on the best investing apps.
