Reviewed by Thomas J. Catalano
Futures and options are both derivative instruments that derive their value from an underlying asset. Each has its advantages and disadvantages.
One of the advantages of options is obvious: An option contract provides the contract buyer with the right but not the obligation to buy or sell an asset or financial instrument at a fixed price on or before a predetermined future month. The maximum risk to the buyer of an option is limited to the premium paid.
Futures have some significant advantages over options, however. They aren’t for everyone but they’re well suited to certain investments and some types of investors.
Key Takeaways
- Futures and options are both common derivatives contracts that hedgers and speculators use on a variety of underlying securities.
- Futures have several advantages over options.
- Futures are often easier to understand and value.
- They have greater margin use and are often more liquid.
- Futures are more complex than the underlying assets they track.
1. Fruitful Investment
Futures may not be the best way to trade stocks but they’re a great way to trade specific investments such as commodities, currencies, and indexes. Their standardized features and very high levels of leverage make them particularly useful for risk-tolerant retail investors. The high leverage allows investors to participate in markets to which they might not have had access otherwise.
2. Fixed Upfront Trading Costs
The margin requirements for major commodity and currency futures are well known because they’ve been relatively unchanged for years. Margin requirements may be temporarily raised when an asset is particularly volatile but they remain unchanged from one year to the next in most cases. A trader knows in advance how much must be put up as an initial margin.
The option premium paid by an option buyer can vary significantly, however, depending on the volatility of the underlying asset and broad market. The more volatile the underlying asset or the broad market is, the higher the premium paid by the option buyer.
3. No Time Decay
The lack of time decay is a substantial advantage of futures. Options are wasting assets. Their value declines over time, a phenomenon known as time decay. Several factors influence the time decay of an option. One of the most important is the time to expiration. An options trader has to pay attention to time decay because it can severely erode the profitability of an option position or turn a winning position into a losing one.
Important
Futures don’t have to contend with time decay.
4. Liquidity
This is another major advantage of futures over options. Most futures markets are very deep and liquid, especially in the most commonly traded commodities, currencies, and indexes. This gives rise to narrow bid-ask spreads and reassures traders that they can enter and exit positions when required.
Options may not always have sufficient liquidity, especially those that are well away from the strike price or that will expire well into the future.
5. Straightforward Pricing
Futures pricing is intuitively easy to understand. Under the cost-of-carry pricing model, the futures price should be the same as the current spot price plus the cost of carrying or storing the underlying asset until the maturity of the futures contract. Arbitrage activity will occur and rectify the imbalance if the spot and futures prices are out of alignment.
Option pricing is generally based on the Black-Scholes model which uses several inputs and is notoriously difficult for the average investor to understand.
Which Is Riskier, Futures or Options?
A lot can depend on your risk tolerance but futures are generally riskier than options.
A futures contract is a binding agreement between a buyer and a seller to trade an asset at a fixed price at a predetermined future month. The buyer and seller are locked into the trade.
That’s inherently riskier than an option trade in which a contract buyer has the right but not the obligation to complete the trade. Even small shifts in the price of the underlying asset can additionally have an impact on trading with futures.
What Futures Are the Most Commonly Traded?
The most frequently-traded types of futures are agricultural, energy, metal, currency, and financial.
Can You Buy Commodities Without Buying Futures or Options?
You can still buy or sell commodities without trading futures or options by purchasing commodity-heavy mutual funds or exchange-traded funds (ETFs). Any such funds would include stocks, futures, and derivatives contracts that track the movements of the underlying commodity.
The Bottom Line
The advantages of options over futures are well-documented. The advantages of futures over options include their suitability for trading certain investments, fixed upfront trading costs, lack of time decay, liquidity, and an easier pricing model.
Disclosure: Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future performance. Investing involves risk, including the possible loss of principal.