Options and Futures Trading Concepts – How They Work

Even if you have been in the business for years, you might still think that the terms “options” and “futures” could be interchangeable. But these are two very different trading instruments and they should be thought of as separate entities.

If you have an option, you have a contract conferring the right to buy an underlying asset at a fixed price, otherwise known as the strike price. You have a right to buy, but it is not an obligation to buy. A futures contract, on the other hand, is an obligation to buy and obligates the seller to deliver the asset by a specific and agreed-upon date.

There can be a variety of underlying assets for futures or options trading. You can see stock, an index, wheat, oil, gold and more. If you trade on the index, the trades would be settled in strictly cash.

Futures are important because they are a way to trade risk, publish prices and take advantage of leverage in the market. If you work in futures, you are essentially trying to predict the future and can make or lose a lot of money doing these gambles. No one knows with certainty what the market price of a particular good will be by the expiration date of a contract and no one will know until the date arrives.

For the contract buyer, if you trade in futures, you can see several values in exchange for agreeing to pay for an amount of goods at a specific price way in advance. In this way, the buyer can take advantage of leverage in the market. If you buy something on futures, you will not have to pay a premium cost.

You will have to put up a deposit, however, usually in the range of 5% of the total cost. You can control 10 – 20x the amount of the goods if you had paid for them at the sale date, however, and not operated through futures.

This form of trading is called a “margin” but it should not be confused as the same “margin” found when buying stocks. In the case of buying stocks, “margin” is when the broker is borrowing the funds for the financial purchase.

Most of the time, very little of the futures contracts actually force the buyer to accept the delivery of the said goods for purchase. Who would want 10,000 barrels of oil in their backyard, for example? Instead, the goods are transferred to brokers who will put the physical goods to better use.

The exchange is a simple one for an experienced trader, however. Any change in the price will be reflected in the accounts at the end of the day’s trading. At some point on an agreed-upon date, the contract will either be sold or expire on its own.

         

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