After spending much time explaining the differences between options trading and futures trading to beginners to derivatives trading, I think its time to touch on the similarities between options trading and futures trading. Is options trading and futures trading really that different? What are some of the similarities? Well, there are actually four main areas in which options and futures are similar.
First of all, options and futures are both derivative instruments. This means that they are both merely contracts that allows you to trade their underlying asset at certain specific prices, hence deriving their value from price movements of their underlying asset. Both options and futures are merely contracts that bind the exchange of the underlying asset at a specific price. Without an underlying asset, options and futures would not have any value for their existence at all, which is why they are known as “Derivative Instruments”. Options and futures both exist for the purpose of facilitating the trading of their underlying asset.
Secondly, both options and futures are leverage instruments. This means that both options trading and futures trading give you the ability to control the price movement on more of their underlying assets than your cash would usually allow. For instance, a futures contract with an initial margin requirement of 10% would allow you to control ten times the amount of its underlying asset than your cash would normally allow you to. A call option asking for $1.00 on a stock that is trading at $20 has a twenty times leverage as it allows you to control a stock worth $20 with only $1. Leverage also means that you could make more profit with options and futures on the same move on their underlying asset than you would if you bought the underlying asset with the same amount of cash. Of course, leverage cuts both ways. You could also potentially lose more than you would in options and futures trading than you would if you had simply bought the underlying asset.
Thirdly, both options and futures can be used for hedging. Hedging is one of the most important usages of derivatives. Both futures and options can be used to partially or totally hedge the directional price risk of an asset even though options are more versatile and precise as it allows for what is known as delta neutral hedging which allows a completely hedged position to still profit should the underlying asset stage a strong breakout in either direction. The hedging power of options and futures is also extremely important in reducing the downwards pressure faced by the overall market during market crisis because big funds and institutions can hedge the downside risk of their holdings using options and/or futures instead of selling their shares in order to maintain their account value. By reducing the amount of selling these big funds does, downside pressure in the overall market is partially relieved. Of course, this alone does not stop bear markets from forming when the general retail crowd (aka the “Herd”) starts to rush out of the market.
Fourthly, both options and futures can be used to profit in ways other than the price movement of the underlying stock itself. Futures spreads can be used to speculate in seasonal price differences between the price of futures contracts of different expiration months and options spreads can be structured to profit from time decay no matter which way the underlying asset goes. Yes, it is these options strategies and futures strategies that make derivatives trading so interesting and so rewarding for people with the knack for mathematical calculations and strategies.
So, even though options and futures are very different derivative instruments and have very different rules and trading characteristics, they are still very much the same in the above areas and you can be a more comprehensive and savvy trader or investor by understanding how to use both options and futures to your advantage.