Deciding whether to trade futures contracts or futures options is one of the first decisions a new commodity trader needs to make. Even experienced commodity traders often waffle back and forth on this issue. Which is the better method for trading?
Contracts and options both have their pros and cons, and experienced traders often use both depending on the situation. Other traders like to focus on one or the other. It's best to fully understand the characteristics of each when you decide how to trade commodities. From there, it's just a matter of using the strategies that make the most sense for you.
- Both futures and options are derivatives, but they behave slightly differently.
- Traders will have an easier time controlling price movement with futures contracts because, unlike options, futures aren't subject to time decay and they don't have a set strike price.
- Traders may have an easier time controlling their risk with long option strategies because the maximum loss is limited to the option premium, and certain spread strategies can help further control risk.
Trading Futures Contracts
Futures contracts are the purest vehicle to use for trading commodities. These contracts are more liquid than option contracts, and you don’t have to worry about the constant options time decay in value that options can experience.
Futures contracts move more quickly than options contracts because options only move in correlation to the futures contract. That amount could be 50 percent for at-the-money options or maybe just 10 percent for deep out-of-the-money options.
Futures contracts make more sense for day trading purposes. There's usually less slippage than there can be with options, and they're easier to get in and out of because they move more quickly.
Many professional traders like to use spread strategies, especially in the grain markets. It's much easier to trade calendar spreads—buying and selling front and distant month contracts against each other—and spreading different commodities, like selling corn and buying wheat.
Many new commodity traders start with option contracts. The main attraction with options for many people is that you can’t lose more than your investment, but the chance of running a negative balance is slim if you only risk a small portion of your account on each trade.
Trading options can be a more conservative approach, especially if you use option spread strategies. Bull call spreads and bear put spreads can increase the odds of success if you buy for a longer-term trade, and the first leg of the spread is already in the money.
Futures options are a wasting asset. Technically, options lose value with every day that passes. The decay tends to increase as options get closer to expiration. It can be frustrating to be right on the direction of the trade, but then your options still expire worthless because the market didn’t move far enough to offset the time decay.
Just as the time decay of options can work against you, it can also work for you if you use an option selling strategy. Some traders exclusively sell options to take advantage of the fact that a large percentage of options expire worthless. You have unlimited risk when you sell options, but the odds of winning on each trade are better than buying options.
Some option traders like it that options don’t move as quickly as futures contracts. You can get stopped out of a futures trade very quickly with one wild swing. Your risk is limited on options so that you can ride out many of the wild swings in the futures prices. As long as the market reaches your target in the required time, options can be a safer bet.
Both Futures and Options Are Derivatives
Think of the world of commodities as a pyramid. At the very top of the structure is the physical raw material itself. All the prices of other vehicles like futures, options, and even ETF and ETN products are derived from the price action in the physical commodity. That's why futures and options are derivatives.
Futures have delivery or expiration dates by which time they must be closed, or delivery must take place. Options also have expiration dates. The option, or the right to buy or sell the underlying future, lapses on those dates.
Long vs. Short Options
Long options are less risky than short options. All that is at risk when you buy an option is the premium paid for the call or put option. Options are price insurance—they insure a price level, called the strike price, for the buyer. The price of the option is the premium, a term used in the insurance business. Commodity option prices are premiums reinforcing the nature of the price insurance, but they become the insurance company when you sell an option. The maximum profit for selling or granting an option is the premium received. An insurance company can never make more money than the premiums paid by those buying the insurance.
Commodities are volatile assets because option prices can be high. The price of an option is a function of the variance or volatility of the underlying market. The decision on whether to trade futures or options depends on your risk profile, your time horizon, and your opinion on both the direction of market price and price volatility.