Futures contracts and options are two methods of trading in the commodities market. The main difference between futures and options is that futures contracts require you to buy or sell the commodity, while options give you the right to buy or sell the futures contract without those obligations.
What are the differences between futures and options?
Futures contracts:
- Contracts between two parties to buy or sell an asset at a specified date. They are bought to gain the option to buy or sell the contract.
- You are obligated to buy or sell the asset. You can choose to buy or sell the futures contract.
- Prices tend to move more, creating greater liquidity.
- They retain greater value over time.
Think of the commodities world as an inverted pyramid. At the bottom of the pyramid is the actual raw material itself. As you move up the inverted pyramid through derivatives, all other commodity prices such as futures, options, mutual funds, and exchange-traded bonds are derived from changes in the actual commodity prices at the bottom.
Explanation of Futures and Options
Futures contracts are derivatives of commodities. This means that traders and speculators do not need to own the physical commodities when they complete their trades. When you buy or sell a futures contract, you take on an obligation to complete the trade at the expiration date.
Options are another type of derivative. Options are also known as “futures options,” which may describe the derivative better. Futures options are essentially options you can buy on a futures contract. They give you the choice between buying or selling the futures contract.
Buying and Selling Futures and Options
Futures contracts have delivery or expiration dates, at which point they must be closed out or delivered. Futures options also have expiration dates. The option, or the right to buy or sell the underlying futures contract, expires on those dates.
Note: A “put option” is the right to sell at a specified price, while a “call option” is the right to buy at a specified price.
You buy a futures call option or a futures put option to make the trade in the direction you believe prices will move.
Price, Liquidity, and Value
Futures contracts are the purest derivative for trading commodities; they are the closest you can get to trading actual commodities without trading them directly. These contracts are more liquid than options contracts. This means that futures make more calculations for day trading purposes. There is usually less slippage in futures compared to options, and they are easier to enter and exit as they move faster.
Futures move faster than options because options only move in line with the futures contract. This amount can be 50% for options in-the-money or only 10% for deep out-of-the-money options. You do not have to worry about the continuous deterioration in value that options can face.
Futures options are assets that decay in value over time. In other words, options lose value with each passing day. This time decay is called time decay, and it tends to increase as options approach the expiration date. It can be frustrating to be right about the trading direction but still have your options expire worthless because the market did not move enough to offset the time decay.
What are some strategies for futures and options?
Many new traders in the commodities market start with options contracts. The main attraction of options for many is that you cannot lose more than your investment. Trading options can be a more conservative approach, especially if you use options spread strategies.
Note: There is a minimal chance of a negative balance if you are only risking a small part of your account on each trade.
It can be…
You can increase your chances of success with revolutionary spread communication strategies and bear spread positioning if you enter a long-term deal and the first leg of the spread is already in the money.
Many professional traders love using spread strategies, especially in the grain markets. It is much easier to trade time spreads – buying and selling contracts from the front month and the back month against each other – and to diversify across different commodities, such as selling corn and buying wheat.
Options selling strategies benefit from options that expire worthless. You have unlimited risk when selling options, but the chances of winning in each trade are better than buying options.
Some options traders appreciate that options do not move as quickly as futures contracts. Futures trading can stop very quickly due to large market fluctuations. The risk is limited in options so that you can ride out many large swings in futures prices. As long as the market reaches your target within the required time, options can be a safer bet.
More about Futures Options
When trading options, you have two positions to choose from – you can take a long or short position based on how prices move. Note: Buying a call or put option is a long position; selling a call or put option is a short position.
Long options are less risky than short options. When you buy an option, all you risk is the premium paid for the call or put option. Therefore, options serve as insurance for a price level, known as the strike price, for the buyer.
Traders often refer to the price of the option as the premium, borrowing this term from the insurance industry. They say the buyer pays the premium, while the seller collects the premium. Thus, the seller acts like an insurance company, while the buyer acts as the insurance consumer. The maximum profit from selling or granting an option is the premium received. An insurance company cannot make more profit than the premiums paid by those who buy insurance.
Conclusion
Commodities are volatile assets for many reasons. This translates to fluctuations in futures and options because prices will follow the commodity. The option price is a function of the variance or volatility of the underlying market.
Trading decisions in futures or options depend on your risk profile, time horizons, and outlook on market price direction and volatility.
Frequently Asked Questions (FAQs)
What is a commodity?
A commodity is a natural resource or agricultural product that is produced and traded in bulk. It can be a raw material used in manufacturing goods or running businesses. Wheat, corn, coal, timber, oil, coffee beans, cattle, metals, and gold are all commodities.
Can I trade commodities without buying futures or options?
You can invest in commodities using commodity exchange-traded funds or mutual funds instead of purchasing individual futures or options. These funds consist of stocks, futures, and derivative contracts that track the price and performance of the underlying commodity. They can provide diversification for your investment portfolio.
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Source: https://www.thebalancemoney.com/should-you-trade-futures-contracts-or-options-809157
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