Futures contracts (futures) and futures options (options) are two ways to trade in the commodities market. The key difference between futures and options is that futures contracts require you to buy or sell the commodity, whereas futures options give you the right to buy or sell the futures contract without that obligation.
What's the Difference Between Futures and Options?
|Are contracts between two parties to buy or sell an asset on a specific date.||Are purchased to have the option to buy or sell the contract.|
|You're required to buy or sell the asset.||You can choose to buy or sell the futures contract.|
|Prices move more, creating more liquidity.||Prices move less, creating less liquidity.|
|Maintain more value over time.||Lose value quickly.|
Think of the world of commodities as an upside-down pyramid. At the very bottom of the structure is the physical raw material itself. As you move up the inverted pyramid through the derivatives, all the prices of other vehicles, like futures, options, exchange-traded funds, and exchange-traded notes, are derived from the price changes of the physical commodity at the bottom.
Futures vs. Options Explained
Futures contracts are derivatives of commodities. This means that traders and speculators do not need to take possession of the physical goods when they complete their transactions. When you buy or sell a future, you take on the obligation to conduct the transaction when the expiration date is reached.
Futures options are another type of derivative. Options are also known as "futures contract options," which might better describe the derivative. Futures options are basically choices that you can purchase on a futures contract. An option gives you the choice to buy or sell the futures contract.
Buying and Selling Futures and Options
Futures contracts have delivery or expiration dates, at which time they must be closed, or delivery must take place. Futures options also have expiration dates. The option, or the right to buy or sell the underlying future contract, lapses on those dates.
A "put option" is the right to sell at a certain strike price, while a "call option" is the right to buy at a certain strike price.
You purchase a future call option or future put option to conduct the trade in the direction you think the prices will move.
Price, Liquidity, and Value
Futures contracts are the purest derivative for trading commodities; they are as close to trading the actual commodity you can get without trading one. These contracts are more liquid than options contracts. This means that 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.
Futures contracts move more quickly than options contracts because options only move in correlation to the futures contract. That amount could be 50% for at-the-money options or only 10% for deep out-of-the-money options. You don’t have to worry about the constant options time decay in value that options can experience.
Futures options are a wasting asset. In other words, options lose value with every day that passes. This is called time decay, and it tends to increase as options get closer to expiration. It can be frustrating to be right about the direction of the trade but have your options still expire worthless because the market didn’t move far enough to offset the time decay.
What Are Some Futures and Options Strategies?
Many new commodity traders start with options contracts. The main attraction with options for many people is that you can’t lose more than your investment. Trading options can be a more conservative approach, especially if you use option spread strategies.
The chances of running a negative balance are slim if you only risk a small portion of your account on each trade.
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.
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.
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 many options expire as worthless. You have unlimited risk when you sell options, but the odds of winning on each trade are better than buying options.
Some options traders like how 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.
More About Futures Options
When trading options, you have two choices for positions—you take a long or short position based on how you think prices will move.
Buying a call or put is a long option; selling a call or put is a short option.
Long options are less risky than short options. When you buy an option, all that is at risk is the premium paid for the call or put option. Therefore, options are considered to be price insurance—they insure a price level, called the strike price, for the buyer.
Traders often refer to the price of the option as the premium, borrowing the term from the insurance business. They would say an option buyer pays the premium, while the option seller collects the premium. Thus an option seller acts more like an insurance company, while an option buyer acts more like an insurance consumer. 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.
The Bottom Line
Commodities are volatile assets due to many reasons. This translates into volatility for futures and options because the prices will follow the commodity. 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.
- 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.
Frequently Asked Questions (FAQs)
What is a commodity?
A commodity is a natural resource or agricultural product that is produced and traded in bulk. It might be a raw material used in manufacturing products or running businesses. Wheat, corn, coal, lumber, oil, coffee beans, livestock, minerals, and gold are all commodities.
Can I trade commodities without buying futures or options?
You can invest in commodities with commodity exchange-traded funds or mutual funds rather than buying individual futures or options. These funds are made up of stocks, futures, and derivatives contracts that track the price and performance of the underlying commodity. They can provide diversification to your investment portfolio.