Five advantages of futures over options

Futures and options are both derivative instruments, which means that their value comes from the underlying asset or instrument. Both futures and options have their own advantages and disadvantages. One of the advantages of the option is obvious. Option contracts provide contract buyers with the right to buy and sell assets or financial instruments at a fixed price on or before a predetermined month in the future, but they have no obligations. This means that the maximum risk for option buyers is limited to the premium paid.

But compared with options, futures have some significant advantages. A futures contract is a binding agreement between buyers and sellers to buy or sell assets or financial instruments at a fixed price in a predetermined future month. Although not suitable for everyone, they are very suitable for certain investments and certain types of investors.

Key points

  • Futures and options are common derivative contracts used by hedgers and speculators on various underlying securities.
  • Futures have several advantages over options because they are generally easier to understand and value, have more margin usage, and are generally more liquid.
  • Nonetheless, futures themselves are more complex than the underlying assets they track. Before trading futures, be sure to understand all the risks involved.

1. Effective investment

For example, futures may not be the best way to trade stocks, but they are a good way to trade specific investments such as commodities, currencies, and indices. Their standardized features and very high leverage levels make them particularly useful for retail investors with risk tolerance. High leverage allows these investors to participate in markets that they might not otherwise have access to.

2. Fixed upfront transaction costs

The margin requirements for major commodities and currency futures are well known because they have remained relatively unchanged for many years. When assets are particularly unstable, margin requirements may increase temporarily, but in most cases, they remain the same from one year to the next. This means that the trader knows in advance how much must be provided as an initial margin.

On the other hand, the premium paid by option buyers may vary greatly, depending on the volatility of the underlying asset and the market. The greater the volatility of the underlying or market, the higher the premium paid by the option buyer.

3. No time decay

This is a significant advantage of futures over options. Options are wasting assets, which means their value will fall over time-a phenomenon called time decay. Many factors affect the time decay of an option, and one of the most important factors is the expiration time. Option traders must pay attention to the time decay, because it will severely erode the profitability of the option position or turn a profitable position into a losing position.

On the other hand, futures do not have to fight time decay.

4. Liquidity

This is another major advantage of futures over options. Most futures markets are very deep and liquid, especially in the most frequently traded commodities, currencies and indices. This leads to narrowing of the bid-ask spread and reassures traders that they can enter and exit positions when needed.

On the other hand, options may not always have sufficient liquidity, especially for options that are far from the strike price or expire in a long time in the future.

5. Direct pricing

Futures pricing is intuitive and easy to understand. Under the holding cost pricing model, the futures price should be equal to the current spot price plus the cost of holding (or storing) the underlying asset until the futures contract expires. If spot and futures prices are inconsistent, arbitrage will occur and the imbalance will be corrected.

On the other hand, option pricing is usually based on the Black-Scholes model, which uses many inputs and is notoriously difficult for ordinary investors to understand.

Bottom line

Although the advantages of options over futures have been fully demonstrated, the advantages of futures over options include their suitability for trading certain investments, fixed upfront transaction costs, no time decay, liquidity, and simpler pricing models.

InvestingClue does not provide tax, investment or financial services and advice. The information provided does not take into account the investment objectives, risk tolerance or financial situation of any particular investor, and may not be suitable for all investors. Past performance does not represent future performance. Investment involves risks, including possible loss of principal.

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