What is the difference between commodity futures and options?

Posted by Karan Sharma on October 4th, 2022

Futures and options are two types of financial products that can be used to benefit from or protect against changes in the price of commodities and perhaps other securities. The primary distinction between the two is that whereas futures allow the contract holder the ability to choose whether to execute the contract, options, as the name implies, give the contract holder the option of choosing whether to buy the investment product on a specified date in the future. This distinction affects how commodity options and futures are traded and priced and how investors can profit from them. Let us go one by one and explain them on a single hand each.

Explanation of Futures

Futures contracts are what is meant when the word "futures" is used. A futures contract guarantees that irrespective of the asset's current market price, the contract holder will purchase the underlying security on a specific date. When they buy the contract, they come to an agreement on a price. It's possible for the underlying asset to be a stock or another financial instrument like oil or corn, which are physical commodities. Your broker won't demand that you stake the entire contract value when you purchase a futures contract. As an alternative, you will just need to hold an initial margin payment—a tiny portion of the cash required for the acquisition. The contract's price will change over time. Your broker might ask you to make a larger deposit if you, as the management and procurement, are displaying an excessive loss. The majority of commodity traders will liquidate a position before it expires. The majority of individuals don't have enough storage room for tonnes of corn or millions of barrels of oil.

Explanation of Options

Puts and calls are the two types of options contracts. The contracts grant the buyer the right, but not the responsibility, to sell the underlying asset by a particular date and at a particular price is Puts. The contracts that give the buyer the option, but not the duty, to purchase the underlying asset at a fixed price by a particular deadline are known as Calls. Another financial product, like a stock, bond, or even a futures contract, serves as the underlying asset. The particular stock is represented by 100 shares in a conventional stock option. The same fundamental units are used in options as in futures contracts for commodities. When you purchase an option, you must pay a premium. Usually, this is only a modest sum in relation to the contract's strike price. This is the maximum amount that is at risk for the buyer of an option. There is no such thing as a dollar limit on the value of an options contract.

To Compare the Differences

Negative pricing is a possibility and reality for futures contracts. This is so because, regardless of market price, holders of futures contracts are obligated to purchase the underlying asset. Therefore, if the asset's value is less than the expense of physically acquiring it, you would have to pay an individual to get the agreement onto your hands. Purchasing a call option is a wager that the value of the primary asset will rise prior to the contract's expiration. Purchasing a put option is a wager that the price will go down. However, even if you choose the winning side of the wager, there is a potential that the value of your options contract will decline before it expires, leaving you with a loss. This is because as time passes, the worth of your selections will decrease. You should earn enough money from the sale of a futures contract to pay off the margin loan and, ideally, make a profit as well. Additionally, If you want to try your hands on options and future commodity trading, the best brokerage firm is IIFL Securities which provides the finest trading facilities in India.