How Options Work
Options are unique contracts that give the buyer the ability—but not the obligation—to purchase or sell an underlying security at some predetermined date and price (the “strike price”). There’s no such flexibility on the short side, however: Should the buyer decide to exercise their option, then the option seller must complete the transaction (i.e., sell to a buyer or buy from a seller).
Like futures, options contracts are standardized and trade on specialized exchanges. Typically, in the case of stock or ETF options, contracts are written for 100 shares of the underlying; but for other assets, such as commodities or currencies, contract sizes can vary widely.
A “call” option gives its owner the ability (but again, not the obligation) to purchase the underlying security at the strike price, while a “put” option gives its owner the ability to sell.
Essentially, options allow investors to express their view on the future price direction of some asset, without having to own the asset itself. That opens up a bevy of sophisticated strategies that allow investors to hedge risks, protect profits and generate income no
matter how the market is moving—if it’s moving at all.
“Generally, options provide more nuanced exposure than futures,” said Kevin Davitt, senior instructor for Cboe’s Options Institute. “They’re subject to dynamics that are less price sensitive, such as volatility. Volatility can be a very good thing if you own options, but a very bad thing if you’re short.”
How Futures Work
In a futures contract, a buyer and a seller agree to exchange a set quantity of some underlying asset at some predetermined date and price. Unlike options—which give buyers the choice of whether to exercise—a futures contract must be fulfilled when it expires, with both buyers and sellers holding up their end of the transaction.
Futures are all about the future. “They’re a purer play on directional price moves,” said Davitt. “If a future moves up from where you bought it, you make money. If it moves down, you lose money.”
Futures can be written for any number of assets or securities: commodities, currencies, interest rates, indexes, even alternative assets like volatility or real estate. The contracts trade on specialized exchanges and are standardized for quantity, expiration date, and delivery time and location.
Because they’re forward-looking, futures are invaluable for hedgers like commodity producers and users, commercial enterprises that buy or sell overseas, and other entities that might need to protect against unfavorable price moves at some future date.
But speculators flock to futures as well, using them to access corners of the market that for logistical reasons might otherwise be off limits. Speculators play an important role in the futures market by providing the liquidity that allows hedgers to offset their price risks.