The terms ‘options’ and ‘futures’ appear together often enough to confuse even knowledgeable traders into thinking they are the same thing. But, while they have important similarities, options and futures are distinct trading instruments.
An option is a contract conferring the right to its buyer to purchase an underlying asset at a fixed price (the ‘strike price’). The right – not the obligation. A futures contract, by contrast, obligates the buyer (the ‘long position’) to purchase and the seller (the ‘short position’) to deliver some asset by a set date.
That underlying asset, in either case, can be a commodity (such as wheat, oil, gold), shares of stock, or some more nebulous instrument such as an index. Since an index is just a number no physical delivery is possible, such trades are settled in cash.
Futures have value as a mechanism for trading risk, publishing prices, and (like options) taking speculative advantage of leverage.
A farmer may not know in April precisely how much wheat he can deliver. Insect damage, droughts and other kinds of crop failure are even today very much real supply problems. Similarly, he can’t predict in April exactly how much demand will exist in October. (In part, that depends on the supply.)
Selling a futures contract allows him to offload that risk to someone willing to bear it. He obtains a set price commitment today in exchange for a promise to deliver a good by a certain date in the future. On the other side of the contract, the buyer offers a promise today to accept delivery of the good in the future.
Neither knows with certainty what the market price will be on the expiration date of the contract, only what the market price is on the day it’s entered.
For the contract buyer, a future offers several values in exchange for accepting the obligation to take delivery of (and pay for) a set amount of goods at a pre-set price.
One major value is, as in the case of options, the use of leverage. While options require paying of a premium (usually around 5%-10% of the current market price), futures have no in-built cost (apart from a small commission).
The buyer is required, though, to put up a ‘good-faith’ deposit, also in the neighborhood of 5% of the total. But that margin deposit allows the trader to control 10-20 times the amount of good he would otherwise have to pay for. That ‘multiplied control’ is leverage.[Note: Though it’s called a ‘margin’, it’s NOT the same as buying stocks ‘on margin’. In the latter case, that is a form of borrowing – with the broker lending the trader the amount needed to purchase all the shares the trader then owns.]
As a practical matter, a very small percentage of futures contracts actually result in the buyer accepting delivery of, say, 1000 barrels of oil. While the behind-the-scenes mechanics are somewhat complicated, at expiration the goods are ultimately transferred to brokers who sell them to those who actually make use of them.
To the traders the exchange is simple, though. Any change in prices is reflected in the accounts of the trading partners at the end of each day’s trade. At some point the contract is either sold (the most frequent result) or expires.