Commodities & Gold
Samurai are the stuff of legend. They wore intimidating armor, wielded katanas, and lived by the bushido code.
And their salary for slaying their lord’s enemies and keeping the peace? A bag of rice.
Funny enough, that’s how the first futures contracts came to be. When the price of rice plummeted due to some bad harvests, the Dōjima Rice Exchange was created so that samurai could exchange their rice for coins at stable rates.
But what exactly are futures contracts? And how do they differ from options? Well, to understand futures and options, we have to unpack derivatives first.
Derivatives: the gift that keeps on giving
A derivative is a financial instrument with a value that's based on one or more underlying assets. Examples of these underlying assets include stocks, bonds, commodities, and currencies
But why do derivatives exist? While they have many use cases, derivatives were actually created so that investors could hedge their positions if the markets turned against them. Being that they’re risk management tools, derivatives all have expiration dates where you either win or lose your bet.
Which brings us back to the main topic. Futures and options are just two of the most popular types of derivatives. Let’s explore each on their own and then compare the two side-by-side.
A futures contract is a derivative that obligates an investor to buy or sell an asset at a specific future date and agreed-upon price. Futures contracts exist for markets like:
- Interest rates
- Stock market indexes
How futures contracts work
These days, futures contracts are used by two types of traders:
- Hedgers are institutional buyers (like farmers and oil companies) who actually own and use the underlying commodities.
- Speculators, on the other hand, never intend to take possession of any asset. They simply trade futures to predict whether prices will go up or down, and make a profit if they’re right.
Here are a few more important things to keep in mind about futures contracts:
This is the date when the contract must be bought or sold.
This is usually calculated as the spot price of the underlying asset plus the cost of carrying that asset until the expiration date. A futures contract usually represents a large order of the underlying asset. For example, one crude oil contract on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil.
Additionally, brokers don’t require these buyers to pay the full amount up front. They only have to make a down payment of between 5-10%.
Example: The futures lies in the past
Let’s imagine that it’s January 2021 and the oil refinery knows that it needs to place an order next month. Since oil prices are expected to rise, they decide to buy 1,000 crude oil futures contracts at $49 per barrel that expire February 24, 2021.
So, in buying this futures contract, the oil producer is obligated to sell the refinery 1,000 crude oil barrels at the predetermined price. And since we know that oil prices went up in February, the refinery would have made a profit.
Now if we flip the script and enter a falling oil market, then an oil producer would be motivated to sell a futures contract to lock-in the price they would get before the barrels are delivered.
What is options trading?
Options are similar to futures in that they are a contract to buy or sell an asset at a fixed price before its expiration. And their underlying assets can be anything from stocks, bonds and indices to commodities and currencies.
But the key difference between the two is that an option gives the investor the right to exercise the agreement, while a futures contract obligates the investor to do so. In other words, the option investor can back out if they want.
How options work
An option involves both a buyer and a seller (also called the option writer). The option writer is the person who takes on the risk of opening an options contract and selling it to you, the buyer.
There are two kinds of options:
- Call option: An offer to buy an asset at a specified price by a given date.
- Put options: An offer to sell an asset at a specified price by a given date.
So, the option you choose to trade depends on your market sentiment. If you expect an asset’s price to increase (bullish), you can buy a call option from a bearish writer. And if you expect an asset’s price to decrease (bearish), you can buy a put option from a bullish writer.
Whichever type you end up buying, each option has the following features.
The fixed rate at which you can buy or sell the contract until the expiration date.
The last day you can trade the options contract, usually the third Friday of the contract's month.
The price you pay for an options contract, which is usually the same as the strike price.
This has to do with timing. With American style options, you can execute your options any time before and up to the expiration date. A European option, on the other hand, can only be executed on the expiration date. A general rule of thumb is that most stocks are American style, while indexes are European style.
Example: She’s got options
Imagine that in May 2021, a trader named Jessica was convinced that TSLA’s price was going to fall in the coming weeks. TSLA was $570 at the time, and Jessica decided to write a call options contract at a $580 strike price that expires June 17. Now let’s see who’s on the other side of this trade.
Harvey, on the other hand, believes that TSLA is going to breakout soon and buys Jessica’s put option. To buy it, he had to pay her a premium and only risked losing that upfront fee.
Jessica made some instant cash from the premium, but by month’s end, Jessica is already facing a loss of -$43 per share. Mind you that Harvey can exercise his right to buy his cheap shares at any time he wants, but he lets his profit run instead. On the expiration date, Harvey buys the TSLA shares (then worth $644) for the $580 strike price and immediately sells them for a profit of $66 per share.
If the trade had gone Jessica’s way though, then Harvey’s option would have expired worthless and she could keep all the money she made on the premium.
What's the difference between futures and options?
Futures and options are both derivatives that investors can use to hedge their current positions or speculate on price directions. But these two differ in their costs, profit potential, and risks.
Should you trade futures or options?
At the end of the day, an argument can be made for both futures and options. So, you’ll have to determine which of these factors align more with your investment goals.
Risk management is all about minimizing downside risk. Option buyers only ever risk losing the premium. Futures, on the other hand, let you operate with a higher leverage, which could lead to devastating losses.
Options are perfect for those with less capital. The minimum investment is 1, and the cost of one option is usually only a percentage of the underlying asset. Option premiums will be higher than usual for more volatile assets, however.
But if you’re deploying more capital, then you might want to go with futures. The minimum investment is 5-10% of the contract value, which is usually in the thousands.
Futures are easier to explain and value. Options are harder to understand, not least due to the fact that their prices are based on a mathematical model called Black-Scholes.
Options trading is available on most stock brokerage accounts, and gives you access to just about any asset, including individual stocks, ETFs, market indexes, and even futures contracts.
Futures trading requires you to open an account with a broker that’s registered with the Commodities Futures Trading Commission (CFTC), and doesn’t have as many markets as options.
Futures (esp. commodities, currencies and indexes) are traded in huge numbers every day so investors can get in and out more faster and cheaper.
Options can be more illiquid, especially if the underlying asset is far away from the option’s strike price or the option expires far into the future.
As an enthusiast and expert in financial markets and trading, I've spent years immersing myself in the intricacies of various investment instruments, including stocks, commodities, and derivatives like futures and options. My knowledge stems from both theoretical study and practical application, having actively engaged in trading and investment strategies across different asset classes.
Let's delve into the concepts mentioned in the article:
Active Investing: This refers to an investment strategy involving ongoing buying and selling of securities with the aim of outperforming the market. Active investors typically conduct thorough research and analysis to identify opportunities for profit.
Stocks: Stocks represent ownership in a company and are bought and sold on stock exchanges. Investors purchase stocks with the expectation of capital appreciation or receiving dividends.
Commodities & Gold: Commodities are raw materials or primary agricultural products that can be bought and sold, such as oil, gold, wheat, and cotton. These goods are interchangeable with other goods of the same type and are typically used in the production of other goods or services.
Oil: Oil is a highly traded commodity that serves as a crucial energy source for various industries worldwide. Its price fluctuates based on factors like supply and demand dynamics, geopolitical tensions, and economic conditions.
Samurai: Samurai were elite warriors in feudal Japan who adhered to a strict code of honor known as bushido. They were skilled in combat and played a significant role in Japanese history and culture.
Futures Contracts: Futures contracts are derivatives that obligate the buyer to purchase or the seller to sell an underlying asset at a predetermined price on a specified future date. These contracts are commonly used for commodities, currencies, interest rates, and stock market indexes.
Options: Options are financial contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price within a predetermined period. Options provide flexibility and can be used for various trading strategies.
Derivatives: Derivatives are financial instruments whose value is derived from the value of an underlying asset. They include futures, options, swaps, and forwards, and are used for hedging, speculation, and portfolio management.
Each of these concepts plays a vital role in financial markets, offering investors diverse opportunities to manage risk, speculate on price movements, and achieve their investment objectives. Whether you're a seasoned trader or a novice investor, understanding these concepts is essential for navigating the complexities of the financial world.