Futures vs. Options Compared (2023): Easy to Understand Examples (2024)

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It is imperative to always try to anticipate the next move. To have options in your future, but what happens when you need to choose between options and futures? 🔮

With COVID-19 keeping everyone indoors, tons of people – established professionals and young college students alike – have started dipping their toes into the stock market.

Except they’re doing more than dip. They’re experimenting with some of the more esoteric aspects of the market by buying and selling futures and options. Even more interestingly, some of them are making big money from this COVID-19-related boredom.

But lots of people don’t understand what the big difference is between futures and options. After all, don’t both contracts lock a stock into a certain price? Let’s break down both investment opportunities and compare them head to head. If you’ve ever wondered exactly what the difference is between the two, this guide has you covered.

What are Futures? 🔮

In a nutshell, futures (futures contracts) are agreements and obligations to buy or sell an asset on a specific date at a specific price. They’re a type of hedge investment, meaning they are an investment that carries reduced risk for adverse price movements for the attached asset.

Futures’ fixed natures at a specific price, regardless of the activity on the rest of the stock market, means that futures are best used for buying and selling staple or cornerstone commodities like oil, potatoes, and other things that will “always” be needed or be valuable. Note, of course, that even things like oil are not necessarily immune to market swings.

Many people use futures to lock in prices that guarantee a certain (though usually not amazing) profit regardless of the stock market’s state at the time.

Examples of Futures Trading 🎯

Both buyers and sellers can use futures to their benefit. A great example is a farmer who might use a futures contract to lock in a price for their crops that guarantees at least some return on investment allowing them to continue farming the same crop for another year.

On the flip side, a buyer for those crops might be interested in purchasing a futures contract. They’ll most often do this in anticipation of prices rising in the near future – by using a futures contract, they avoid having to pay an exorbitant price for a staple crop. The farmer, meanwhile, avoids any uncertainty and avoids the catastrophe of the price for their crop sinking and not being able to make a profit.

A more specific example might see two traders agree to a $100 price per barrel of oil. If the price of oil moves up to $105 by the date of the futures contract, the buyer will need to pay $100 per barrel regardless of the increased price, so they save money by purchasing it for less than it’s worth. On the flip side, the seller of the oil didn’t make as much profit, but avoided the risk of oil dropping to $70 a barrel and having to sell it anyway.

A big overall point is that futures contracts require you to go through with your end of the bargain regardless of the current market value for the underlying asset.

🏅 Great Tip: After you gain an understanding of futures, it’s time to find the right broker. We’ve compiled a report of the top futures brokers, comparing their strengths and weaknesses.

What About Stock Futures? 🧠

These futures contracts work the same as futures for actual commodities. Traders must still buy or sell the underlying stocks in a futures contract on the agreed-upon date and price.

Who Uses Futures the Most? 💭

Because futures result in locking down a price for an underlying commodity or stock, institutional buyers or bulk buyers of various goods make heavy use of futures contracts. In the aforementioned farmer example, they might use futures to ensure a decently profitable season by forgoing market risk. They may not make bank, but they won’t go bankrupt, either.

Risker traders might still use futures contracts as a type of gamble on the price for the underlying asset. For instance, a stock trader might buy a stock at $100 a share, anticipating that the market will actually result in that asset’s value dropping to $50 a share. If they manage to lock in those futures contracts, their buyer will have to pay a much higher than average price at the agreed-upon date.

What are Options? 🤔

Options are also not stocks, but are contracts are a little more flexible compared to futures contracts. Options provide investors with the right, rather than the obligation, to buy or sell shares or commodities at a specific price at any time within a contract’s time range.

While the level of complexity can quickly pile up, it’s crucial to full grasp what options trading is prior to jumping in and investing.

Futures require you to buy or sell the stock or asset at the agreed-upon price at an agreed-upon time. Options just give you the option to buy or sell a stock at a particular price, but you don’t have to. Options contracts do have expiration dates, however, so the locked-in price is only good for a while.

Options are also hedge investments. However, they do not represent actually owning any underlying asset until the actual trade goes through. Options are essentially opportunities to buy or sell so you can take advantage of stock market swings and dips.

Most options contracts are worth 100 shares of whatever underlying asset they deal with. In most cases, buyers pay “premiums”, which are representative of an asset’s strike price, to purchase an options contract. The strike price is a going rate for buying or selling the asset until the options contract expiration date.

How Does the Expiration Date Work? 📅

It’s just a deadline before which the contract must be used or discarded. Many investors who buy options will hold onto their options contracts for some time before expiration to see how the market swings with their assets’ values.

Examples of Options Trading 💡

Say that an investor decides to buy an options contract for Stock A at a $100 strike price within the next month. The stock might currently only be trading at $90.

The stock value on the market goes up to $120, so the original investing buyer can buy that stock at $100 instead of $120: a great investment, since then the buyer can turn around and immediately sell the stock for a whopping $20 profit per share.

Another option example involves selling. Say that the original buyer sees that the value for the above stock is $120. They can then sell the options contract itself and take the additional profit. Someone else might take on that options contract and do with it what they will.

Similarly, if the original investor decides to purchase a sell option at $100, and the stock’s price drops to $80, they still reserve the right to sell the stock at $100 a share regardless of the current market value. This also represents a potential profit if they can find a buyer.

📈 Ready to trade options? The next step is selecting the ideal broker for options trading according to your experience and investment strategy.

How are Futures Different From Options? ⚔️

Let’s summarize the main differences between futures and options:

• ☑️ Futures require you to buy or sell a stock or asset at an agreed-upon price and time.
• ☑️ Options give you the opportunity to buy or sell at a certain price.
• ☑️ Options contracts don’t force you to do anything.
• ☑️ Futures contracts do represent actually owning the underlying assets.
• ☑️ Options contracts don’t represent ownership of underlying assets.
• ☑️ Futures contracts lock in both parties, requiring that they buy and sell regardless of their current finances or the market environment at the time of the deal.

Both futures and options can be opportunities for great profit on your part. But futures are more often used for products or assets that are expected to never really go down in value.

They’re “safer” investments in the sense that they guarantee a particular price for their attached assets. In this way, it’s easier to plan your financial strategy using futures contracts.

Note that their reliance on big commodities and currencies mean that futures’ prices tend to follow the general market trend. COVID-19 optimism, for instance, has recently caused futures prices to soar.

Options are safer for those without a lot of leverage or personal capital, however, and you only have to pay the premium price to enter an options contract. You are not obligated to pay anything else at any point.

Both futures and options can be traded through mobile apps or a number of trading platforms, or you can contact a futures or options broker.

Advantages of Trading Futures 📈

There are many reasons besides the above why people might choose to trade with futures over options, and even other types of stocks.

For starters, futures contracts are fantastic if you primarily trade with major commodities and currencies. These assets or products usually have pretty well-known margin requirements for profits – this just means that profits for fundamental assets like foodstuffs, gold, and other currencies aren’t often volatile and can be easily predicted.

You can use futures to eliminate any remaining uncertainty and guarantee a profit within a certain margin no matter what. This, in turn, allows you to buy more assets for the next year and continue the cycle.

Compared to options, futures do not experience “time decay” – the idea that some assets lose value over time. Options usually lose value as they get closer to their expiration time. Futures aren’t affected by time decay since their prices and trading times are set from the beginning.

Furthermore, futures markets are usually quite liquid – there are usually plenty of buyers and sellers and transaction costs are typically low. Again, this is because futures contracts are usually utilized for staple commodities and currencies.

This means finding a buyer or seller for an asset at specific prices is often quite easy. It’s a lot harder to find some options buyers or sellers for particular strike prices.

Finally, futures contracts are pretty easy to understand, as are their pricing. The overall concept of an option – buying or selling the option to buy or sell an asset at a set price – is a little more counterintuitive and vague. With futures, prices for contracts should be around the same as the current market price for the underlying asset, along with any ancillary carrying or storage costs.

How are Futures Taxed? 🧾

Futures’ taxation codes are relatively straightforward. The Internal Revenue Code Section 1256 states that any futures contracts traded on US exchange, foreign currency contracts, and other common contracts are taxed as long-term capital gains at rates of 60% or short-term capital gains at rates of 40%.Additionally, the maximum total tax rate is 23%.

Let’s break this down. Long-term capital gains are any monetary gains you earned from selling capital assets that you own for more than one year. Short-term capital gains are the same gains, but those you earn from selling capital assets you own for one year or less.

Here’s an example. If you buy a contract worth $10,000 and the value goes up to $20,000 by the end of the same year, you’ll recognize a $10,000 capital gain for that year’s tax return. That’s a short-term capital gain so it should be taxed at 40%.

On the flip side, if you buy that same contract worth $10,000 and you end up making $20,000 profit on it over two years, you’ll recognize $20,000 in profit on the next year’s tax return. This would be taxed at 60% as a long-term capital gain.

Advantages of Trading Options 💪

There are also lots of reasons you might decide to trade options contracts. While they are complex, there are a variety of strategies for options trading that can be utilized. There’s no obligation to actually buy or sell what the options contract pertains to, so there’s limited financial risk aside from the initial investment you pay for the contract itself.

This does insulate you a little bit from the possibility of owing a lot of money, which remains a risk with futures contracts. Remember, if your futures contract expires at an unprofitable price, you are obligated to pay that cost no matter what.

On the other hand, if an options contract expires and the underlying asset isn’t at a great price, you can just let the contract expire. You might have wasted a little bit purchasing the contract in the first place, but it may not be such a big deal compared.

Options might also be a great choice since they make speculation quite cheap by comparison. There are tons of options in the overall market, and many of these are quite affordable.

As such, they represent an inexpensive way to bet on the market with very little long-term risk. You can still lose a bit of money over options if you purchase lots of contracts that expire in rapid succession, of course.

Lots of people are experimenting with options purely because of this low barrier to entry.

Furthermore, the majority of options market participants don’t buy options contracts on leverage (basically debt or borrowed value). As such, you’ll most often buy options contracts without exceeding the maximum loss your portfolio can take.

In other words, it’s a rare thing to buy options contract and accidentally throw your financial future into total jeopardy by purchasing a contract that’s worth far more than your total value.

Lastly, options contracts are more responsive by nature. With futures contracts, you cannot the contract to buy or sell at a fantastic price for your circ*mstances. But with options, the moment you see an opportunity for huge profits, you can use that contract to either buy or sell for great gains.

How are Options Taxed? 📜

The taxation codes for options are a little more complex than those for futures.

To start, your trades and any capital gains are taxed as short-term if an options contract’s trading period lasts for less than a year. Any gains you make are long-term if the trade lasts for more than a year.

Meanwhile, if you have a previously bought option and it expires “unexercised” (i.e. didn’t end up buying or selling the underlying assets), you will also face short or long-term capital loss, with the same time windows above dictating whether it counts as short or long-term.

If you write an option, your gains are recognized as short or long-term based on your closing circ*mstances or when you made or lost money from the contract.

Rules are a little simpler if you, as a contract buyer, exercise your options contract. Whenever you exercise a “call” option, any premium you pay for that option will be added to the cost basis for the shares you now have an options contract for. Your trade is taxed as either short or long-term depending on how long you hold the shares before selling them back.

If you exercise a “put” options contract, you are taxed on short-term capital gains if you hold the shares for less than a year. You are taxed on long-term capital gains if you hold the shares for longer than a year.

All of this can be quite complex. The IRS has a handy table detailing the tax rules for options contract buyers and sellers for more specific aspects to this overview, and you can use that to help minimize your tax losses.

Futures and Options: Summary 🎬

Ultimately, futures and options can be attractive contracts and are useful hedge investments. Both can be very smart investments if you want to lower your capital risks or play the stock market, as they can be good ways to guarantee a set minimum profit or minimize your losses. Let us know what you think of futures and options and whether you have any preference for trading with either.

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.