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For many individual investors, options and futures are exotic instruments. This is far from the case, once you learn the difference between the two.
The truth is that with widespread availability of brokers catering to individuals, buying an option or a futures contract can be just as easy as buying a stock.
Still, there are many reasons why trading options is better for most of us than futures. And we will cover those today.
It all has to do with the specific types of leverage you can enjoy in futures and options trading. A small amount of money can "control" the underlying asset and allow you to profit by almost the same dollar amount as buying the underlying asset.
The same dollar profit on a smaller initial outlay means a large percentage gain. Of course, leverage works both ways, so a little extra education is important.
The Difference Between Options and Futures
With leverage being the main benefit, there are important differences between options and futures. Perhaps the biggest difference is the amount of money required to play.
Options can be had for pennies on the dollar, and that means the total price for an options contract that controls 100 shares of the underlying stock can be less than $100.
Futures are typically a lot more expensive, although the introduction of e-mini contracts two decades ago brought down the cost. The e-mini S&P 500 futures contract, for example, costs $50 times the value of the S&P 500 Index.
At recent prices, that would mean one e-mini contract costs 3,870.29 * $50 = $193,514.50. For reference, the full-size S&P 500 contract would cost five times that. It is no wonder that the full-size contract has fallen in popularity.
As you can guess, such a price is out of reach for most investors, but most trading is done on margin. Investors need only put up a small amount of money, perhaps $500, to buy, as long as their account has a minimum value in case the trade goes the wrong way.
If you buy a contract and its price falls, you may be required to put more money into your account. With options, the money you pay up front is the most you can lose.
The second difference is strike prices. Options offer a variety of strike, or exercise, prices so you can build strategies to suit your needs. With futures, you either own it or you don't. Futures are simpler in this regard, but they do not offer complete flexibility.
The third difference is liquidity. The more popular futures contracts, such as the major stock index contracts, certain commodities, and Treasury Bonds are very active and liquid markets.
You won't have to worry too much about fair and efficient buy and sell prices. Options, because they have a large array of strike prices, spread out that liquidity, so any given options contract could be less liquid.
That is why we recommend only certain types of options on any given stock, which we will cover later.
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Finally, futures are obligations to either make or take delivery of the underlying asset, whereas options give the holder the right but not the obligation to make or take delivery. For index futures, they are settled in cash. You cannot deliver an actual S&P 500, but you can deliver its value.
Commodities futures require that you either deliver a specified amount of commodity somewhere or you have to receive that commodity, depending on whether you bought or sold the futures contract.
That was one reason why oil prices went negative in the middle of 2020. It was better to pay someone to take your oil than accept delivery and then have to store it in an oversupplied market.
While there are options on commodities and indexes, the most popular market is for options on stocks and stock indexes. Conversely, while there are futures on single stocks, the most popular market is for indexes.
Since trading commodities takes a different skill, let's focus just on stock indexes.
Here is the comparison:
|Relatively low price offers high leverage.||Relatively low price using margin offers high leverage.|
|The right but not obligation to make/take delivery.||The obligation to make/take delivery.|
|Liquidity concentrated in most active strikes and most active expirations, and it moves over time and price changes.||The most active futures are highly liquid.|
|Wide array of strategies available using time, strike, and combinations.||Only a few strategies possible using time.|
|Typically, the only money you risk is the price you paid to open the trade.||With margin, when a trade goes against you, you may have to add more money, raising your risk.|
The real advantage in futures is that all eyes are focused on one specific futures contract for any underlying asset. That makes the top futures contracts extremely liquid.
However, options offer the flexibility of strike price and expiration date to mold strategies to your needs. They have lower costs, and with the exception of strategies we do not recommend (naked shorting), your risk is limited to what you pay to open the trade.
In order to overcome the problem of spread-out liquidity in options, we usually recommend a strike price that is close to the underlying stock price and with expiration dates about three months away.
This is where the most activity typically resides. It is also not a coincidence that stock index futures also expire every three months.
When you weigh all factors, options trading is better suited for most people than futures trading. Risks are lower, flexibility is higher, and we can overcome the liquidity issue by restricting the universe of options we trade.
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