Options vs Futures: Which should you trade?
Should you trade options or should you trade futures? It’s a tough question. The answer? Well, that
Should you trade options or should you trade futures? It’s a tough question we get asked almost daily. The answer? Well, that largely depends on your risk tolerance.
While these financial instruments are similar in many ways ..
- Both are derivatives, meaning they derive value from an underlying asset;
- Both are about as equally as popular among retail traders; and
- Both provide unlimited potential for profits.
.. their markets are very very different.
Now we are not saying that you necessarily have to choose between options and futures - we certainly have channels dedicated to both instruments, with analysts that focus on options, analysts that prefer futures and analysts that trade both.
However, if you are just beginning on your trading journey, our advice is to focus on mastering one first. Once you understand the market, develop a strategy that works for you, and are consistently profitable - move on to the other. Baby steps.
To help you decide which instrument will be a better fit for your trading style, we delve into the characteristics of both options and futures.
Stock options are financial instruments that give an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. We’ll go through the basics below but if you want a more in-depth look at trading stock options, we’ve covered the topic here.
There are two types of options contracts:
- Calls: Use when the stock price is expected to rise.
- Puts: Use when the stock price is expected to fall.
Call options give the buyer the right to buy shares at a set price within a set time period. Put options give the buyer the right to sell shares at a set price within a set time period.
During this time period, the market is free to move either up, down or sideways and this will affect the price of the options contract.
Before the options contract expires, an investor can either:
- sell their options to another buyer (hopefully for a profit);
- execute the contract if they wish to buy/sell shares in the underlying company: or
- do nothing. After the time period is up, the contract will expire if the option isn’t exercised.
A futures contract is an agreement that two parties will trade an underlying asset at an agreed-upon price and date. Unlike options, a futures contract obligates the parties to fulfill the terms of the contract. The buyer of a futures contract must buy and the seller must sell, unless the holder’s position is closed before the settlement date. Traders can close out futures positions selling/buying an identical contract.
The underlying asset can be a security, commodity or financial instrument. From crude oil, wheat, gold, silver, Euro’s, British Pounds, Treasury Bonds, and the S&P 500 Index.
Futures markets typically involve using a high amount of leverage as traders do not need to pay for the entire contract’s value upfront. The main two ways to trade futures are speculating and hedging.
- Futures Speculating — Where a trader takes a punt on the direction of the underlying’s price movement. A trader can either buy a speculative position if they think the price of the underlying will go up or sell/short a speculative position of the underlying price is expected to fall.
- Futures Hedging — Where a trader enters into a futures contract to reduce the risk of price changes in their overall portfolio. For example, a wheat farmer can enter into a futures contract to sell their wheat at a favorable price. This will protect the farmer from future negative price movements of wheat.
Futures were originally created as a way for farmers and dealers to commit to future exchanges, while also protecting both parties from volatile price swings. Most Futures traders today have no intention of taking possession of any of the underlying products. Traders will buy and sell speculative plays to profit from price changes. When it comes time for settlement, the contract will be settled in cash unless the contract is designated for ‘physical delivery’.
What’s the difference between Options and Futures?
Now that you understand how to trade these instruments, we explore the major differences between Options and Futures to help you decide which one is better suited to you.
Risk and Leverage
When buying options, the risk is pre-defined and is limited to the options premium paid to enter into the contract. Selling options involves far greater exposure to the options writer whose risk is potentially infinite as the stock price could significantly move against them. However, when you sell options the odds of winning on each trade can be higher than buying options.
For futures, contracts are valued by the price of their underlying assets so there is no way to exactly know just how much you stand to gain or lose.
Using leverage adds a whole other element of risk. You can use leverage to enter into both options and futures positions. However, the extent of risk is different as futures often use a substantial amount of leverage.
A trader can enter into a futures position with 10 times as much leverage to capital. While using leverage is a powerful way to exponentially increase profits, it comes with enormous risk. Highly leveraged futures positions with large contract sizes expose traders to huge potential losses for even fractional price movements. As the futures market tends to move faster than the options market, a good judgment call can net a futures trader quick profit. But the losses are magnified and can come just as quickly.
Premiums and Margins
When entering into an options contract, the premium is paid upfront.
For Futures, traders don’t pay a premium. Rather, they put down the initial margin to open a futures position. The initial margin is established by the exchange and is normally a small percentage of the futures contract. The trader will also need to sustain a maintenance margin in their trading account for the duration of the contract — the maintenance margin will be specified in the contract terms.
From there the margin balance will be adjusted every day in a process called mark-to-market. This is where the value of the position is calculated and the profit or loss is transferred into the trader’s account at the end of the trading day. If the margin drops below the maintenance level, the trader will receive a margin call and will be required to top up margin funds or reduce or liquidate the position. The remaining payment and commissions are settled at the end of the contract.
Options premiums are generally much smaller than futures initial margins. While an out-of-the-money options call can set you back less than $100, the initial margins for futures contracts are well into the thousands.
Options are decaying assets. As the option contract moves closer to expiration, it’s value is expected to decline as there are fewer chances (or time) for the option to turn profitable. To measure how the passage of time affects an options price, we use Theta. You can read more about Theta and the other Option Greeks here.
In contrast, Futures contracts are not negatively affected by time decay. This is because Futures contracts are not optional — they must be executed at the contract price on the delivery date. So regardless of whether you enter the trade a day or a year before the delivery date, the passage of time is one less thing you have to consider with a futures contract.
Pattern Day Trader Rule
The Pattern Day Trader (PDT) rule is an industry-standard implemented by the Financial Industry Regulatory Authority (FINRA) that applies to many securities including options.
The Pattern Day Trader Rule effectively places a cap on the day trading activities of retail traders with less than $25,000 in their margin accounts. A trader who executes four or more ‘day trades’ within five consecutive business days will need to maintain a minimum balance of $25,000 in their margin accounts at all times.
While options are regulated by FINRA, Futures, and Futures Options are regulated by the National Futures Association (NFA) and are not bound by the PDT rule. This means that day trading Futures do not count towards a retail trader’s PDT.
Liquidity and Overnight Trading
Options are typically traded during the regular US stock market session time from 9:30 am to 4:00 pm ET. This is the time where there are the most buyers and sellers in the market and options contracts are at their highest liquidity. While many brokerages now offer after-hours trading, these sessions are not ideal for retail traders. During these outside times, when there is not much participation in the options market, traders will have to deal with more erratic price action, increased slippage, and wider spreads between bid and ask prices.
On the other hand, the Futures market is open for business almost 24 hours a day from Sunday evening through to Friday afternoon. They are also some of the most robust and liquid markets with huge amounts of contracts traded every day. This gives rise to narrow bid and ask spreads while also reassuring traders that they will be able to enter and exit positions quickly and around the clock. This flexibility in trading hours is a huge benefit for traders also working a 9–5 job, and overseas traders as time difference isn’t so much of a challenge.
Let us preface this discussion by stating that we are not tax professionals, this is not tax advice and the reader is of course encouraged to do their own due diligence and consult with a tax professional before trading any instrument.
Now that’s out the way, let’s get to the crux of the matter. The tax treatment of Futures can be much more favorable (and much less complex) than that of Options, especially for scalpers and swing traders.
Under Section 1256 of the US tax code, Futures contracts are taxed on a 60/40 percent basis of long-term capital gains rates and short-term capital gains rates, irrespective of how long the trade was held. This means that 60% of the trade will be taxed at the maximum long-term capital gains rate of 15% and 40% of the trade will be taxed at the maximum short-term capital gains rate of 35%, meaning that the maximum total tax rate will be 23%.
On the other hand, the tax treatment of Options is far more complex and takes into account the length of the trade and whether the trader was the writer or holder of puts or calls. Trades held for less than a year will often be taxed at the short-term capital gains rate while trades held for over a year will often be taxed at the long-term capital gains rate.
Which is more profitable, Futures or Options?
Both Options and Futures have unlimited profit potential where not even the sky’s the limit.
However, at the end of the day whether you decide to trade options or you decide to trade futures is mostly going to come down to your risk appetite. Trading futures is not for the faint of heart. As futures typically require high amounts of leverage, one wild price swing in the wrong direction can be financially devastating.
But for traders with a high-risk tolerance, proper risk management, unbiased and unemotional trader mentality, and the capital to back it up, futures trading offers a number of advantages over options trading. But until you have all those qualities locked down, stick to buying options for the time being.
Australian lawyer. Living in Asia. Writing about Law, Finance, Wall Street & Startups. Echelon-1.com