Comparison of option types (6) – FX Options

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Contents

HOW TO TRADE FX OPTIONS WITH IQ OPTION – REVIEW AND WALKTHROUGH

Overview:

      13 forex pairs available + commodities and indices Uncapped profitability (for successful trades) Expiry time every 1 hour Choose between different strike prices Profit from rising or falling markets (in the case of winning trades) Enjoy IQ Option’s trading apps, technical indicators, and widgets

RETAIL EU TRADERS CAN NOW TRADE FX OPTIONS, WHICH IS A GREAT ALTERNATIVE TO BINARY OPTIONS.

European retail traders who fancy binary options will be pleased to know that IQ Option now offers an alternative to binary options – FX options. Retail traders from the European Union do not have access to IQ Option’s binary option and digital option instruments anymore due to ESMA (European Securities and Markets Authority) regulation, but they are now able to trade the FX options offered by IQ Option. Before we go into detail about the differences between FX options and binary options, let’s first take a look at FX options.

More About IQ Option’s FX Options

IQ Option’s FX options cover 13 forex currency pairs, Crude Oil Brent, Crude Oil WTI, gold, silver, and 7 stock indices. FX Options can be traded with the following expiry times: 10 minutes, 20 minutes, 30 minutes, 40 minutes, 50 minutes, and 60 minutes. However, because trades can be entered late, a trade’s actual expiry time may be less than the times mentioned above. For example, a 10-minute FX option contract can be entered more than 9 minutes late, which means that you can actually enter a trade which expires in less than 1 minute. Likewise, if you entered 5 minutes late on a 40-minute FX option contract, your actual expiry time would be 35 minutes from the moment you entered the trade.

Positions taken on FX option contracts can be closed prematurely (before the expiration time) and have virtually unlimited profit potential (for successful deals). Also, in the case of out-of-the-money trades, the amount which is lost can in some cases be less than 100% of the investment amount.

FX Options Versus Binary Options – What are the Differences?

Strike Price

With binary options, traders can only trade at the current strike price of the options contract but with FX options, they can choose between a number of different strike prices which are available at that particular time.

AN EXAMPLE OF AN FX OPTION ON THE EUR/USD WITH DIFFERENT STRIKE PRICES TO CHOOSE FROM.

Risk to Reward Ratio

Each binary option contract offers a reward that is less than the possible loss. For example, with an investment of $100 in a binary options contract with a profitability percentage of 90%, a trader will gain $90 (at expiration) in the case of a winning trade and lose $100 (at expiration) in the case of a losing trade.

Certain binary option contracts can be closed prematurely. In this case, the loss may be less than 100% of the investment amount in the case of a losing trade and the profit (in the case of a winning trade which is closed prematurely) will also be less than the maximum profit which might have been gained at the time of expiration.

On the other hand, FX options have the advantage of much more flexibility when it comes to risk to reward ratios. On each individual FX options contract, traders cannot lose more than the amount they invest. However, because they can choose the strike price, they have the ability to alter the risk to reward ratio. So instead of being limited to a maximum payout of, for example, 90%, they can achieve gains which are basically unlimited.

Contract Duration / Expiration Times

There is a notable difference between the expiration times available with binary options and FX options. IQ Option’s binary options (excluding OTC binary options) can be traded with expiry times that vary between 30 seconds and 30 days. There are a couple of expiries between 30 seconds and 10 minutes as well as two longer contracts, namely ‘end of the day’ and ‘end of the month’.

As explained already, FX Options are expiring every hour. So, the big difference is, that with FX options, you don’t have access to the ‘end of the day’ and ‘end of the month’ expiries like you have with binary options.

Trading Availability Throughout the Week

While FX options can only be traded 5 days a week, certain binary options can be traded over weekends when FX options (and standard binary options) are not available. These instruments are called OTC (over the counter) binary options.

Currency Pairs / Instruments Available

When comparing FX options with binary options, we find that IQ Option offers many more binary options than FX options. With binary options, clients can trade roughly 34 currency pairs, 22 stocks, two stock indices, and gold. On the other hand, FX options are currently available in 13 currency pairs, 4 commodities, and 7 stock indices. The number of instruments available in binary options and FX options can change at any time, and IQ Option will probably add more instruments currency pairs to the group of FX options soon.

Best Binary Options Brokers 2020:
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    Binarium

    The Best Binary Options Broker 2020!
    Perfect For Beginners and Middle-Leveled Traders!
    Free Demo Account!
    Free Trading Education!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Good Broker For Experienced Traders!

Regulation

As mentioned earlier, retail traders from the European Union are not able to trade binary options and digital options with IQ Option due to ESMA (European Securities and Markets Authority) regulations. On the other hand, retail EU traders are able to trade IQ Option’s FX options which comply with ESMA’s regulations.

With FX options, IQ Option has made a way for retail EU traders to trade a type of options contract that replaces the binary options that were previously available to them!

Different Platforms for Trading FX Options

CAUGHT IN ACTION: AN OPEN FX OPTION TRADE ON THE EUR/USD EXECUTED ON IQ OPTION’S MOBILE APP.

Retail EU traders who fancy FX options can trade it via IQ Option’s web, desktop, Android, and iOS platforms.

IQ Option Platform / Account Features

Fully Functional Demo Account (Free)

IQ Option’s demo or practice account is really worth mentioning. It has all the features of a real money account and does not expire like many other demo accounts. With this demo account, traders can practice with $10,000 virtual money and acquaint themselves with the markets and trading instruments before trading with real money. This account can be topped up to the original value of $10,000 at any time, which is a pretty convenient feature. Traders can also switch between their real and demo accounts without even leaving the trading platform. Don’t forget that IQ Option’s demo account is yours to use free of charge!

Low Minimum Deposit and Minimum Investment Amount

With a deposit of only $10, clients can access a real money account with IQ Option and start trading certain instruments like forex pairs, stocks, and commodities with an investment amount of only $1. FX options require a minimum investment amount of 25 euro or $30, however.

Indicators, Graphical Tools, and Widgets

IQ Option’s trading platform is equipped with all the tools you may need:

  • Technical indicators – Moving averages, oscillators, ATR, Ichimoku Cloud, Fractal, and many more.
  • Different chart types – Line charts, candlestick charts, bar charts, and Heikin-Ashi.
  • Graphical tools – Different lines including Fibonacci.
  • Widgets – See the following widgets right on your charts: ‘Traders’ Mood’, ‘High and Low Values’, ‘Other Traders’ Deals’, ‘Volume’, and ‘News’.

Customer Support

IQ Option clients can easily contact its support team via the ‘Chats and Support’ tab on the left side of the trading platform. At the bottom left of the platform you will also see a telephone number that you can call 24/7. The chat feature is also available at any time of the day and week. Customer support is available in 13 languages.

Trading Education

On the trading platform itself, traders can access video tutorials for free. These videos cover different subjects, which include information on FX options, binary options, digital options, different chart patterns, how to use different technical indicators, CFD trading, and the Crypto Digest.

Traders thoughts: Which of the types of options is better to choose for trading. Comparison of common types of options

Now many of the binary option brokers offer many kinds of options. This makes it difficult to choose for many traders. Both beginners and professionals. Well, in this case, many will be useful reading this article.

For amateurs, it will be useful to remember what option means. This is a contract that does not oblige, but gives the right to make a deal to buy or sell a certain number of assets at a certain time.

Options are divided into 2 main types: Call and Put. Call gives the right to purchase. Put is the right of sale. Combines these two types of options is the way of making profit on it. This profit is the difference between buying and selling these two kinds of options.

Options are also divided by “territorial units”:

American options and European options, what to choose

Like all existing types of options, they are similar to each other. But this information for the trader will not be so valuable.

Then let’s look at their differences:

  • In our case, the main difference we take is the right to execute the contract In American options, the trader or the owner is given the opportunity to fulfill the obligations under the contract until the expiration of the option.
  • In European options, the same option is provided only after the expiration of the option. In other words, it will not be possible to complete the deal prematurely, as in the case of American options.

Based on this information, we can assess the risks involved in trading these types of options. Consequently, European options will be cheaper than American ones. Since the risk in the performance of trading operations for American options will be significantly lower. But, which type to use in trading – this is the business of every trader.

We all know that options have become very popular in America, after which the wave has reached European countries. Almost all types of stock options belong to a variety of American. And the indices have already learned to be well used in European countries.

The essence of Classic and traditional options

Classic options are not real contracts, they are contracts for the price difference of certain assets of “CFD”. And as already many of you have understood, they are not classed as traditional. All types of options that are listed in the article are derivative financial instruments. But the real contracts of them are only American and European, since CFD is income exclusively from the dynamics of price movements on a certain scale. Regarding real contracts, you do not purchase – CFDs and, accordingly, do not sell the underlying asset.

How does the process of trading classical and traditional options occur :

  • The minimum amount of assets to trade for traditional options is 100 units, for classical options 1 unit. Also the number may vary depending on the broker and the amount of the transaction.
  • Commissions and brokerage fees are imposed on all the traditional options, on the classic this is less common. Since the fact of buying and selling assets itself does not carry a trade transaction.
  • Compensation of additional broker’s expanses in traditional options is very low. In the classic, you can close the deal at break-even level and, most importantly, prematurely.

What conclusions can be drawn

As you have already read classic options have a number of advantages over American and European. The availability of trading of such options is much better than that of traditional ones. So, for everyone who has always wanted to try to trade classical options, feel free to do it.

We advise you to try trading on the IQ Option platform. Click on the button below to open a demo account.

Essential Options Trading Guide

Options trading may seem overwhelming at first, but it’s easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.

Key Takeaways

  • An option is a contract giving the buyer the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a specific price on or before a certain date.
  • People use options for income, to speculate, and to hedge risk.
  • Options are known as derivatives because they derive their value from an underlying asset.
  • A stock option contract typically represents 100 shares of the underlying stock, but options may be written on any sort of underlying asset from bonds to currencies to commodities.

Option

What Are Options?

Options are contracts that give the bearer the right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expires.   Options can be purchased like most other asset classes with brokerage investment accounts. 

Options are powerful because they can enhance an individual’s portfolio. They do this through added income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal. A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. Options can also be used to generate recurring income. Additionally, they are often used for speculative purposes such as wagering on the direction of a stock. 

There is no free lunch with stocks and bonds. Options are no different. Options trading involves certain risks that the investor must be aware of before making a trade. This is why, when trading options with a broker, you usually see a disclaimer similar to the following:

Options involve risks and are not suitable for everyone. Options trading can be speculative in nature and carry substantial risk of loss.

Options as Derivatives

Options belong to the larger group of securities known as derivatives. A derivative’s price is dependent on or derived from the price of something else. As an example, wine is a derivative of grapes ketchup is a derivative of tomatoes, and a stock option is a derivative of a stock. Options are derivatives of financial securities—their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, forwards, swaps, and mortgage-backed securities, among others.

Call and Put Options

Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. If you buy an options contract, it grants you the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date.

A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a stock. Think of a call option as a down-payment for a future purpose. 

Call Option Example

A potential homeowner sees a new development going up. That person may want the right to purchase a home in the future, but will only want to exercise that right once certain developments around the area are built.

The potential home buyer would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at say $400,000 at any point in the next three years. Well, they can—you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant such an option for free. The potential home buyer needs to contribute a down-payment to lock in that right.

With respect to an option, this cost is known as the premium. It is the price of the option contract. In our home example, the deposit might be $20,000 that the buyer pays the developer. Let’s say two years have passed, and now the developments are built and zoning has been approved. The home buyer exercises the option and buys the home for $400,000 because that is the contract purchased.

The market value of that home may have doubled to $800,000. But because the down payment locked in a pre-determined price, the buyer pays $400,000. Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the home buyer must pay the market price because the contract has expired. In either case, the developer keeps the original $20,000 collected.

Call Option Basics

Put Option Example

Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called the premium, for some amount of time, let’s say a year. The policy has a face value and gives the insurance holder protection in the event the home is damaged.

What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor wants insurance on his/her S&P 500 index portfolio, they can purchase put options. An investor may fear that a bear market is near and may be unwilling to lose more than 10% of their long position in the S&P 500 index. If the S&P 500 is currently trading at $2500, he/she can purchase a put option giving the right to sell the index at $2250, for example, at any point in the next two years.

If in six months the market crashes by 20% (500 points on the index), he or she has made 250 points by being able to sell the index at $2250 when it is trading at $2000—a combined loss of just 10%. In fact, even if the market drops to zero, the loss would only be 10% if this put option is held. Again, purchasing the option will carry a cost (the premium), and if the market doesn’t drop during that period, the maximum loss on the option is just the premium spent.

Put Option Basics

Buying, Selling Calls/Puts

There are four things you can do with options:

  1. Buy calls
  2. Sell calls
  3. Buy puts
  4. Sell puts

Buying stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock.

Buying a put option gives you a potential short position in the underlying stock. Selling a naked, or unmarried, put gives you a potential long position in the underlying stock. Keeping these four scenarios straight is crucial.

People who buy options are called holders and those who sell options are called writers of options. Here is the important distinction between holders and writers:

  1. Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent.
  2. Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in-the-money (more on that below). This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more, and in some cases, unlimited, risks. This means writers can lose much more than the price of the options premium.   

Why Use Options

Speculation

Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call option—instead of buying the stock outright—is attractive to some traders since options provide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared to the full price of a $100 stock.

Hedging

Options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn.

Imagine that you want to buy technology stocks. But you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way. For short sellers, call options can be used to limit losses if wrong—especially during a short squeeze.

How Options Work

In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option would be that profits from that event. For instance, a call value goes up as the stock (underlying) goes up. This is the key to understanding the relative value of options.

The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminish as we draw closer to expiry. This is why an option is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day. Since time is a component to the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa.

Accordingly, the same option strike that expires in a year will cost more than the same strike for one month. This wasting feature of options is a result of time decay. The same option will be worth less tomorrow than it is today if the price of the stock doesn’t move. 

Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibilities of substantial moves both up and down. Greater price swings will increase the chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way. 

On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that’s why you must multiply the contract premium by 100 to get the total amount you’ll have to spend to buy the call.

What happened to our option investment
May 1 May 21 Expiry Date
Stock Price $67 $78 $62
Option Price $3.15 $8.25 worthless
Contract Value $315 $825 $0
Paper Gain/Loss $0 $510 -$315

The majority of the time, holders choose to take their profits by trading out (closing out) their position. This means that option holders sell their options in the market, and writers buy their positions back to close. Only about 10% of options are exercised, 60% are traded (closed) out, and 30% expire worthlessly.

Fluctuations in option prices can be explained by intrinsic value and extrinsic value, which is also known as time value. An option’s premium is the combination of its intrinsic value and time value. Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the amount above the strike price that the stock is trading. Time value represents the added value an investor has to pay for an option above the intrinsic value.   This is the extrinsic value or time value. So, the price of the option in our example can be thought of as the following:

Premium = Intrinsic Value + Time Value
$8.25 $8.00 $0.25

In real life, options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely.

Types of Options

American and European Options

American options can be exercised at any time between the date of purchase and the expiration date. European options are different from American options in that they can only be exercised at the end of their lives on their expiration date. The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type.   Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.

There are also exotic options, which are exotic because there might be a variation on the payoff profiles from the plain vanilla options. Or they can become totally different products all together with “optionality” embedded in them. For example, binary options have a simple payoff structure that is determined if the payoff event happens regardless of the degree. Other types of exotic options include knock-out, knock-in, barrier options, lookback options, Asian options, and Bermudan options.   Again, exotic options are typically for professional derivatives traders.

Options Expiration & Liquidity

Options can also be categorized by their duration. Short-term options are those that expire generally within a year. Long-term options with expirations greater than a year are classified as long-term equity anticipation securities or LEAPs. LEAPS are identical to regular options, they just have longer durations.

Options can also be distinguished by when their expiration date falls. Sets of options now expire weekly on each Friday, at the end of the month, or even on a daily basis. Index and ETF options also sometimes offer quarterly expiries. 

Reading Options Tables

More and more traders are finding option data through online sources. (For related reading, see “Best Online Stock Brokers for Options Trading 2020”) While each source has its own format for presenting the data, the key components generally include the following variables:

  • Volume (VLM) simply tells you how many contracts of a particular option were traded during the latest session.
  • The “bid” price is the latest price level at which a market participant wishes to buy a particular option.
  • The “ask” price is the latest price offered by a market participant to sell a particular option.
  • Implied Bid Volatility (IMPL BID VOL) can be thought of as the future uncertainty of price direction and speed. This value is calculated by an option-pricing model such as the Black-Scholes model and represents the level of expected future volatility based on the current price of the option.
  • Open Interest (OPTN OP) number indicates the total number of contracts of a particular option that have been opened. Open interest decreases as open trades are closed.
  • Delta can be thought of as a probability. For instance, a 30-delta option has roughly a 30% chance of expiring in-the-money.
  • Gamma (GMM) is the speed the option is moving in or out-of-the-money. Gamma can also be thought of as the movement of the delta.
  • Vega is a Greek value that indicates the amount by which the price of the option would be expected to change based on a one-point change in implied volatility.
  • Theta is the Greek value that indicates how much value an option will lose with the passage of one day’s time.
  • The “strike price” is the price at which the buyer of the option can buy or sell the underlying security if he/she chooses to exercise the option. 

Buying at the bid and selling at the ask is how market makers make their living.

Long Calls/Puts

The simplest options position is a long call (or put) by itself. This position profits if the price of the underlying rises (falls), and your downside is limited to loss of the option premium spent. If you simultaneously buy a call and put option with the same strike and expiration, you’ve created a straddle.

This position pays off if the underlying price rises or falls dramatically; however, if the price remains relatively stable, you lose premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sure which direction.   

Basically, you need the stock to have a move outside of a range. A similar strategy betting on an outsized move in the securities when you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration—known as a strangle. A strangle requires larger price moves in either direction to profit but is also less expensive than a straddle. On the other hand, being short either a straddle or a strangle (selling both options) would profit from a market that doesn’t move much.   

Below is an explanation of straddles from my Options for Beginners course:

Straddles Academy

And here’s a description of strangles:

How to use Straddle Strategies

Spreads & Combinations

Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg. Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration, but a different strike.

A bull call spread, or bull call vertical spread, is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one.   Similarly, a bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a calendar spread or time spread. 

Spread

Combinations are trades constructed with both a call and a put. There is a special type of combination known as a “synthetic.” The point of a synthetic is to create an options position that behaves like an underlying asset, but without actually controlling the asset. Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options.   

Butterflies

A butterfly consists of options at three strikes, equally spaced apart, where all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one).

If this ratio does not hold, it is not a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor – the difference is that the middle options are not at the same strike price. 

Options Risks

Because options prices can be modeled mathematically with a model such as the Black-Scholes, many of the risks associated with options can also be modeled and understood. This particular feature of options actually makes them arguably less risky than other asset classes, or at least allows the risks associated with options to be understood and evaluated. Individual risks have been assigned Greek letter names, and are sometimes referred to simply as “the Greeks.” 

Below is a very basic way to begin thinking about the concepts of Greeks:

Futures vs. Options

The biggest difference between options and futures is that futures contracts require that the transaction specified by the contract must take place on the date specified. Options, on the other hand, give the buyer of the contract the right — but not the obligation — to execute the transaction.

Both options and futures contracts are standardized agreements that are traded on an exchange such as the NYSE or NASDAQ or the BSE or NSE. Options can be exercised at any time before they expire while a futures contract only allows the trading of the underlying asset on the date specified in the contract.

There is daily settlement for both options and futures, and a margin account with a broker is required to trade options or futures. Investors use these financial instruments to hedge their risk or to speculate (their price can be highly volatile). The underlying assets for both futures and options contracts can be stocks, bonds, currencies or commodities.

Comparison chart

Futures versus Options comparison chart
Futures Options
Transaction mandatory Yes; the buyer and seller are both obligated to complete the transaction on the specified date at the price set in the contract. No; the buyer has the option but not the obligation to complete the transaction. The seller is obliged to transact if the buyer of the option chooses. The price at which the transaction will occur is set in the option contract.
Transaction date The date specified in the contract Any time before the expiry date specified in the contract
Standardized contract? Yes Yes
Traded on exchanges? Yes Yes
Daily settlement? Yes Yes
Margin account required? Yes Yes

Contents: Futures vs Options

What are Futures?

Futures contracts are agreements to trade an underlying asset at a future date at a pre-determined price. Both the buyer and the seller are obligated to transact on that date. Futures are standardized contracts traded on an exchange where they can be bought and sold by investors.

What are Options?

Options are standardized contracts that allow investors to trade an underlying asset at a specified price before a certain date (the expiry date for the options). There are two types of options: call and put options. Call options give the buyer a right (but not the obligation) to buy the underlying asset at a pre-determined price before the expiry date, while a put option gives the option-buyer the right to sell the security.

Options are Optional, Futures are Not

One of the key differences between options and futures is that options are exactly that, optional. The option contract itself may be bought and sold on the exchange but the buyer of the option is never obligated to exercise the option. The seller of an option, on the other hand, is obligated to complete the transaction if the buyer chooses to exercise at any time before the expiry date for the options.

Why Are Options and Futures Used?

Many businesses use options and futures to hedge their risks, such as exchange rate risk or commodity price risk, to help plan for their fixed costs on items that frequently change in value. For example, importers may protect themselves from the risk of their home currency falling in value by buying currency futures that give them more certainty in their business operations and planning. Similarly airlines may use options and futures in the commodities market because their business depends heavily on the price of oil. Southwest Airlines famously reaped the rewards of their hedging strategy for oil prices in 2008 when the price of a barrel of oil reached over $125 because they had purchased futures contracts to buy oil at $52.

Prices for options and futures contracts are highly volatile — much more so than the price of the underlying asset. So investors may also use them for speculating. Brokers require margin accounts before they allow their clients to trade options or futures; often they also require clients to be sophisticated investors before they enable such accounts because volatility and risks with options and futures trading are significantly higher compared with trading the underlying asset e.g. stocks or bonds.

Options can be used to reserve the right to purchase or sell an item at a predetermined price during a set time period. For instance, a real estate investor might hold an option to purchase a piece of property during a time period while they determine if they can get the funding and permits they need. Such options, although not exchange-traded, give the buyer the “right of first refusal” when someone makes an offer on a property.

Important Options and Futures Terminology

For both options and futures, there are certain terms that are important to know. In the world of options, the terms “put” and “call” are key to the business. A “put” is the ability to sell a certain asset at a given price. A “call” is the ability to purchase an item at a pre-negotiated price. The price itself is called a “strike price” or an “exercise price.” In addition, options usually come with an “expiration date.” This date is the date by which the option would need to be put into action, otherwise the option will become null and void.

Futures have their own terminology as well. The “exercise price” or “futures price” is the price of the item that will be paid in the future. Buying an item in the future means that the purchaser has gone “long.” The person selling the futures contract is called “short.”

What can be Optioned?

There are many items that can be optioned. Options can be exercised on a wide variety of stocks, bonds, real estate, businesses, currency and even commodities. Frequently used in the investment world, options can also be used by privately held companies and individuals as a way to hold the right to purchase or sell something of value. Options do not guarantee a sale; they only provide the right to it.

What assets can be covered under a Futures contract?

Futures cover a myriad of items. Futures can be traded for currency, stocks, interest rates and other financial vehicles as well as commodities such as crude oil, grain and livestock. Unlike options, a futures contract is binding and the contract must be fulfilled per the terms of the agreement.

Popularity in the financial industry

Futures and options are a significant part of the financial trading industry and are roughly equally popular, with options having a slight advantage in volume. According to FuturesIndustry.org, during the first half of 2020, 5.46 million futures contracts and 5.66 million options contracts were traded. [1]

References

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