Options vs. Futures: What’s the Difference?
(Last Updated On: 4. October 2021)
As opposed to many other websites describing the topic options vs. futures, I don’t agree with the statement that options and futres are derivative investments. There are not at all! What they are is that they are derivative trading instruments (or derivative products, methods or whatever). But they are not investments! Though I agree that there are several similarities between both: they are both speculative, they can be highly profitable and, if you handle them in a wrong way, highly risky. In this article I will show you the difference of options vs. futures. So let’s start, folks.
What Are Options?
First, let’s answer the question “What are options”. It would go too far beyond the scope to explain everything in detail so here comes a brief explanation. By the way, if you are interested in trading options and would like to learn it from scratch, I can recommend you to enroll an online course about trading options*.
Usually, options are used by institutional market participants as insurance instruments to protect themselves against losses either in the stock market or commodity markets. In other words, institutional market participants are using options for hedging purposes. They can either buy options or sell options. But usually, they are buying them, and they pay a premium to the option sellers.
Those persons who get the premium are called premium holders and they would be liable in case a “damage” would occur. You can compare the whole concept with a regular insurance. When you pay a premium to an insurance company, e.g. for your car, you’re protected because in case you get involved into a car accident, the insurance company would pay for the damage. That’s why it has got a premium from you.
I think, with this brief explanation you should get the first insight and understanding about what options are. There is much more to tell about options and there are a lot of different terms to discuss about, such puts and calls, strike, implied volatility, underlying, expiration, the rights and the duties you would have by trading options, and so on. But for beginners it would be too confusing to read all about this in just one article. In this case, I just again can recommend you to participate in an online course*, either a paid one or you just gather the information for free on YouTube step by step.
But that’s it what options were invented for, to protect the professional market participants from losses. Options are a type of derivative product, meaning their value is linked to the value of the asset they represent — called an underlying. In many cases the underlying is stocks, but it can also be ETFs or commodities.
How to make money trading options in general
As mentioned, options can be bought and sold either on securities (like stocks, ETFs) or on futures, and you can make money with both methods.
By buying options, you can gain exorbitant yields, at least in theory. The other side of the coin is that you would need to pay money first before you can milk the cow. Considering the risks, you can only lose the amount of money you took to pay for options. In other words, your risk is limited.
By selling options, your profit would be limited. One thing you need when you sell options is to have some money in your trading account as a kind of security bond. In the financial world this security is called “margin“. But selling options can mean that your risk can be unlimited or at least much higher than in case when you’re buy options.
Reading this, you might think that the situation is clear: buying options is the best method to make a pile of money by a limited risk, right? Unfortunately, the reality is different and that’s the catch in the whole story:
Statistically, your chances to make money buying options is much lower than selling options. The statistical advantage lies around 30% or less that a bought option would make profits at the end. Of course, you can indeed make money buying options. But in this case, you need to be a master trader. Or at least, a much better trader compared to the others. In my article about buying options, I’m giving you a brief insight into this specific topic.
Selling options, on the others hand, is much more profitable. The profit is limited but provided you know what you are doing, the success rate lies around 80%. And there are possibilities to limit the risk in options selling, too (at the expense of profit reduction).
That’s why successful options traders are usually make money by selling options. Of course, the risk in this case can be unlimited but when you learn how to trade in general, you can limit your risk. One requirement to limit your risk is not only to have a good risk management but also to be a good chart analyst. You need to know how to read chart formations and to read technical indicators. There are a lot of good books out there about technical analysis* but also some good online courses* about it.
How much money can you make by trading options?
Professional traders, the real good ones, are making in average around 30% annually. But to be humble, between 12% and 20% annually should be possible, depending on the market situation. At least for you, as a private trader.
Is it possible for you to make 30%, too? Frankly, yes as long as you have good trading skills. And for you as a private trader it’s actually easier to make 30% than for a professional one.
The reason for this is that private traders usually have small trading accounts, compared with those of professional traders. As private trader, you usually would have around $15K. Maybe more. But professional traders have accounts far beyond of a $1 Million Dollars. And to make 30% with a $10K account is much easier than with a $1 million account.
But as a beginner, your goal would be to make your first 100 trades and not to lose money. In other words, after your first trades you would be successful when you would have at least the same money you started with.
Risk in options trading
As I mentioned it above, the risk lies in the way you trade options. When you buy options, your risk would be limited. But as option buyers have much lower chances to profit from this type of trading, your risk as options buyer lies in the fact that you could spend all of your money buying options and not to make any profits.
For option sellers it’s a different story. When you sell, you get the money. But then you would be liable for a “damage case” which would mean your risk is unlimited. When you don’t have a proper trading strategy, no decent risk management and position management, you could lose all of your money literally over night.
What Are Futures?
Now, let’s check the futures which were there long before options were invented.
The first futures were used in Chicago in the year 1851 between grain merchants and other grain traders to guarantee a price for a produce, like wheat.
The situation was like following: a local grain merchant sitting outside of Chicago bought grain from local farmers who were growing wheat or corn, e.g. along the Illinois River. Then, when the merchant had enough grain to ship, he brought it by boat to Chicago to sell it there. But sometimes, the rivers were too long (or too soon) frozen so he stuck with the produce at his place and had to store it in corn cribs until the next spring or summer.
So it happened that because of this, there was too much grain available which drove the prices down because when the merchants finally could ship the produce to Chicago, there was a glut in the markets. In this case it could happen that the river merchants made a loss. Sometimes the prices were such low that it wasn’t even worth for them to ship the crops to Chicago and they just dropped it into the river.
To get more certainty and lock in the prices, the merchants started to make agreements with the traders in Chicago. They would say something like this: “the rivers are still frozen and I can’t ship my produce to Chicago. But when you agree to buy my produce right now and not in a couple of months, I will give it to you for one cent cheaper than the current market price. You don’t need to pay me right now, just do it when I have shipped the crops to your place.”
To seal the deal, they used contracts they signed to make it official. That’s how all started. Since then, there was a lot of development. What started with contracts between some merchants and traders in Chicago to lock in prices for corn and wheat, extended to a lots of different commodities like eggs, onions, live cattle, pork bellies and even on shrimps or chicken. More later, new futures were developed like futures on bonds, stocks or currencies. The latest development is the introduction of the futures on Bitcoin. If you would like to know more about the history of futures and their upcoming in the world of trading, I can recommend you to read a book about history of futures* by Emily Lambert.
And that’s what futures are: they are a form of a contract stating that traders must buy or sell a given asset at a predetermined price. Similar to options, futures are also a derivative instruments (not investments!). As mentioned above, they represent commodities, but can also deal with securities and other financial assets.
In other words: the market for futures was created to protect institutional traders. But it was created much longer before options.
If you ask yourself, why market participants are using options and not futures instead, I can tell you that locking in the price with a futures contract is not always favorable for one contract party. Imagine, our merchant from our example from above got his money by selling the crops one cent cheaper than the current market price. But what if the price of the crops would fall after that? The trader who bought the crops could have bought the crops a couple of months much cheaper. But who could know that the prices would drop?
Therefore, using an option to protect from this disadvantage is a very good method and that’s why options were invented. Our crops buyer could buy an option after he signed the contract with the merchant and in case the prices would fall after that, he would have been protected because he would take the money from the option seller in case the prices would drop and reach a certain level.
How to make money trading futures in general
In the world of institutional market participants, the practice of trading futures is most commonly used for locking in prices and for physical delivery of whatever the futures were traded on.
But in the world of private traders and professional traders who are not interested in physical delivery, they are popular for day trading purposes or at least, for position trading (Which lasts a couple of days or weeks. But in this case you would close the position before it comes to a physical delivery).
People who are trading futures must be familiar with the commodity they are trading, so they can predict price movements and the main advantage of trading futures is for sure its leverage, for a futures contract contains a certain amount of value.
For example: a futures contract for Sweet Crude Oil (Exchange symbol: CL) encompasses 1000 barrels of oil. When a barrel of sweet crude oil costs around $50, hence, one contract would be worth of $50.000
And every futures type has a defined minimum movement step, also known as the “tick size”. On Sweet Crude Oil, the tick size is defined as 1 US-Cent for one barrel. With a contract size of 1000 barrels and a tick size of 1 US-Cent, you would gain (or lose) $10 when the price of the future contract moves just 1 US-Cent.
Therefore, if you are a good (day) trader, you can make a real quick money by trading futures because of the leverage.
Risks of trading futures
As opposed to options, your risk in futures trading is always unlimited. This unlimited risk is additionally reinforced by the leverage I mentioned above. When you consider that a movement of just one cent in Crude Oil can cause a profit or loss of $10; imagine what happens when the price drops $1. In this case your loss would be $1000, and this can happen within minutes (in some extreme cases).
Of course, there are some methods to reduce your risk, e.g. by hedging with options. But that’s another story and therefore, the statement that you have unlimited risk in futures trading is still valid. As you see, in case of futures trading, you need a proper strategy and risk management, too.
By the way, your biggest risk factor are yourself no matter if you are trading options or futures. You can have the best strategy and the best risk management but if you don’t follow your own rules because you get greedy, you will experience a miserable failure. Therefore, trading psychology is very important you should train. If you’re interested in trading psychology as a beginner, I can recommend you the book: “Mastering Trading Psychology“*
How much money can you make by trading futures?
Well, this question is (as opposed to options) no easy to answer. In the world of options, where the profits (in case of selling options) are limited, the profits are more predictable. In the world of futures, on the other hand, the sky is the limit. At least in theory. It all depends on your trading skills, your trading psychology and your account size.
But just for a comparison: If you are a master trader, annually, you could make $100.000 with an $10.000 account. And yes, such cases are indeed real. But in general, as a profitable trader, you would have a good day when you would make daily $300 – $500 in average.
To achieve these profits, you should have $50.000 in your account when you decide to trade futures which would be a good starting point. Of course, you can also start with muss less money, but in this case the risk to drive you account to zero would increase. And that’s what you don’t want, right? Your goal should be to accept losses in short term but to keep the game running in the long perspective. And you would increase your chances with a bigger account.
Options vs. Futures: main differences
Futures and options can both be great trading instruments. Although they have similarities, there are several differences to be aware of. Here are some key differences when looking at options vs. futures:
- Asset type: While futures and options can deal with the same asset types, they are generally used for different things. Institutional market participants from the manufacturing sector are using futures to lock in prices for the physical delivery once a futures contract expires. Speculative market participants are using futures for day trading or position trading to profit from the price movements. With options, market participants usually hedging themselves additionally to the futures. Because as you have read it above, locking in prices can be disadvantageous in some cases.
- Implied volatility: in the world of options, the determinant lies in the so-called implied volatility. Every options seller is looking for a high implied volatility to get as much premium as possible. Option buyers are looking for a low implied volatility to buy an option for the most cheap price. In the world of futures, implied volatility does not play an important role. What’s important there, are price movements.
- The risk in some cases: Although option sellers have a theoretical unlimited risk, option buyers have a limited risk. They have to pay for an option a full premium. But in return, they would only risk the amount of money they had paid. In the world of futures, on the other hand, both buyers and sellers have unlimited risk.
- The money you can earn: Although you have unlimited risk when you trade futures, you can earn much more money than in case of trading options. The prerequisite for this is, of course, that you are a good trader and know what you are doing. In the world of options, the option seller always has a limited profit from the trade (Option buyers have, at least statistically, chances of unlimited profit. But that’s another story and before you start buying options like crazy: as I mentioned it, the statistical chance of profits for option buyers is much lower than for option sellers. For this, again, check my article about making money on buying options).
- Account size: In trading futures, you need a bigger money account. This is because gains or losses on futures positions automatically marked to “market daily”, meaning the change in the value of the positions affects the accounts at the end of every trading session.
In other words, at the end of the day, you will get cash booked into your account in case of a profit. In case of a loss, you will get money withdrawn from your account. On the internet I found some ridiculous information that you can trade futures with just a $500 account. But this is not realistic if you would like to do futures trading in a long run and even to make money from this for a living. Therefore, an account size of around $50.000 would be a good starting point.
In the world of options, your account will not be balanced till you (or your broker when you exaggerated it) have closed the position. You should have around $15.000 if you would like to trade options on stocks and around $50.000 in case you would like to trade options on futures.
- Time to invest: trading futures can be pretty time consuming. I’ve heard about day traders spending around 14 hours in front of their computers. Those are for sure extreme cases but at least, when you trade just during the US trading session, you need to spend time in the first 2-3 hours at the beginning of the session because there is the most action ongoing.
In options trading, when you are experienced enough, you would need to spend about 20 minutes daily to check your positions and to look for new trade opportunities. I’ve heard from some options traders that they even check their positions just every third or fourth day (during a regular, boring trading season which occurs most of the time).
Please keep in mind that these were just some key differences. I’ve skipped the details because for beginners, I tried to keep the theory as simple as possible. If you would like to know more about options and options trading, I recommend you to check some information, e.g. on YouTube or, if you like it more educational, to enroll a paid online course*, e.g. on Udemy.
Options vs. Futures: Which Is Best For You?
Both futures and options can be profitable investments — so how do you choose which is the best trading instrument for you?
Well, the answer is simple: you need to try out both methods. To do this, you even don’t need to bring your own money into the game, thanks to paper trading accounts the most brokers are offering.
Just open an account at the broker of your choice and play around with the paper trading account. Learn the theory about trading and practice it.
Please note: to become a sustainable profitable trader no matter in what, you should be patient and invest in 3 – 5 years to train your trading skills (depending on your average time investment and learning pace). In case you have heard on Reddit or Discord about some “successful” traders made a lot of money quickly, I just can say that they had either luck or they’re not honest with the audience. If trading would have been an easy job, the world would be full with billionaires or at least, millionaires. But it’s not, right? It’s because 90% of all private traders are losing money with trading but that’s another story.
*Affiliate link: when you click on this link, no additional costs would arise for you and the product or the service will not become more expensive. When you decide to buy the product or use the service, I’ll get a little benefit from the provider which I would reinvest to keep this blog alive.