Options and futures contracts can both be exciting trading opportunities to forex traders, but it is important to know the differences between these two securities and when they should be used. For starters, it might help to review some basics. Options and futures are both derivatives, financial instruments designed to help participants either increase or decrease risk.
While these can help investors meet their objectives, securities certainly do not provide a guarantee of success. Using either options or futures always comes with a high degree of risk, and forex traders should be sure to do their homework and/or seek advice from an independent financial advisor before they work with either of these securities.
As we review the differences between options and futures, it might help to start by detailing the most basic difference between the two. An option grants the contract holder the ability to either buy or sell an underlying asset for a specific price within a predetermined time frame. In contrast, a futures contract obligates two parties to make an exchange at a certain time.
One key difference is that an option provides the contract holder with rights, while a futures contract obligates the two sides to make a transaction.
Basic Contractual Differences
Options contracts include an underlying asset, a specific quantity of that asset, a strike price and an expiration date. The strike price dictates the price at which the holder can buy or sell the underlying asset, while the expiration date specifies how much time the holder has to make the aforementioned transaction.
For example, a forex trader might purchase a call option on EUR/USD based on his expectation the currency pair will rise in value. If EUR/USD currently trades for 0.80, the investor could buy a call on the currency pair that has a strike price of 0.90 and expires six months from now.
In contrast, futures contracts contain more information. They indicate the underlying asset, contract size, the settlement method, the delivery date and the settlement price. While there are many different kinds of futures, forex futures generally have a size equal to a certain amount of a currency, for example €125,000.
In addition, these contracts are required to provide a minimum price increment and also a tick value, which indicates the smallest price movement they can experience. For example, a EUR/USD futures contract with a size of €125,000 might have a minimum price increment of 0.0001 and a tick value of US$12.50.
Futures always trade on exchanges, while options can trade both on and off exchanges. Investors trade futures on a short list of marketplaces including the Chicago Board of Options Exchange, the New York Mercantile Exchange and the Kansas City Board of Trade.
At this point, almost all futures trading is done electronically. For many years, these transactions were handled in futures trading pits, where traders used verbal communication and hand signals to make trades. These were referred to as open outcry trading methods.
In February 2015, exchange operator CME Group announced that by July 2 of that year, it would close down the majority of its open outcry trading pits in Chicago and New York. CME Group declared it planned to make this move as open outcry volume had plunged to 1% of the company's futures trading volume.
Later that year, the exchange operator pushed this deadline back to July 6, 2015. CME Group attributed this change in plans to an alteration in its filing with the U.S. Commodity Futures Trading Commission.
While futures trading is done only through exchanges and for the most part electronically, many options contracts are set up off-exchange or "over the counter." To establish such a contract, two parties can negotiate terms and come to an agreement. Once these steps have been taken, they have a bilateral contract.
Many investors appreciate using this approach, as it grants them the ability to customise the terms of each contract. With this flexibility, they may find it easier to manage risk effectively.
Another key difference between options and futures is the risk they carry. If a trader purchases an options contract, the most he can lose is the initial investment plus any transaction costs. Should he sell covered calls, or call options on assets he owns, his loss is limited to the appreciation of the underlying securities minus the premium gained by writing the calls.
However, the holders of a futures contract are obligated to participate in the agreed-upon exchange.
While trading futures contracts can help participants manage risk, it can also cause them to experience significant financial loss. For example, if wheat is currently trading for US$4.75 a bushel, a farmer might sell a broker his entire harvest for US$4.50 per bushel in order to lock in a certain price.
If the price of the commodity surges toUS$9 per bushel, the farmer may lose out on some potential gains. However, should wheat plunge in value, the broker could suffer major losses.
Do Your Homework
If you are considering trading either options or futures, be sure to conduct substantial due diligence and/or consult an independent financial adviser, as using these financial instruments can generate both significant gains and sizable losses. Knowing the basics of these investments inside and out is essential.
Once you have built the proper foundation by learning about the basics, training with a practice account can be highly beneficial for developing familiarity with placing, following and closing trades, for example. Doing so will provide the opportunity to learn and gather feedback on one's trades without risking one's principal.
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