Futures trading is an investment process that enables traders to profit by taking advantage of cost and price differences between the commodity they bought and sold. An options contract allows an investor to take advantage of price fluctuations without buying or selling the underlying security itself. But how do these two trading strategies differ?
What Is Futures Trading?
Futures Trading enables buyers and sellers to purchase goods at a future date at a specific price. A futures contract has a buyer and seller, but there’s also a third party: the clearinghouse who ensures that all contracts offered for sale or purchase will be honoured when it comes time for delivery. The clearinghouse becomes the buyer to every seller and seller to every buyer of a futures contract.
In most cases, both parties are required to deposit margin with their respective brokers as collateral against a possible market decline. In some cases, especially if the parties agree on delivery months in advance, only one party has to post a margin.
Margin deposits are usually a fraction of the contract’s total value. The Federal Reserve Board regulates them, allowing only small percentages of the market value of its currency contracts for speculation while allowing more significant percentages for hedgers who face uncertain future costs or prices.
Benefits Of Futures Trading
Futures trading is complex and has lots of benefits for people involved in it. Some of these benefits include:
- Speculation on commodities with low initial margins
- Ability to increase buying power through leveraging
- Availability of futures on all sorts of underlying assets (stocks, currencies, indices, metals etc.)
- Hedging risks associated with any business activity (including farming)
Risks of Futures Trading
There are obvious risks to trading futures including:
- Can not control future events
- Lack of control over price fluctuations
- Asset prices can devalue as the expiration date is on the horizon
What Is Options Trading?
An option contract is a binding agreement that gives an investor the right, but not the obligation, to buy (call) or sell (put) a predetermined amount of stocks at an agreed-upon price within a specified time frame. You can make money even if the stock price doesn’t move. Options give investors more flexibility than purchasing stocks, making it possible to limit potential losses but still reap the benefits of potential gains.
There are two types of options contracts; calls and puts. Calls give their owners the right to buy securities at a fixed price within a specific time frame. This means if the underlying security price goes up between buying and selling, you will profit from purchasing calls. Puts give their owners the right to sell securities at a fixed price within a specific time frame. This means taking advantage of downward movements in stock prices by buying put contracts.
In general, your profit from buying call or put options is equal to the difference in price between the strike prices and the underlying security’s price at the expiration.
Benefits Of Options Trading
One of the first Benefits of Options Trading is that you can make money regardless of whether the stock goes up or down. It is not uncommon for stocks to go up, down, or stay flat on any day, week, month or year. Options trading does not limit you to just profiting on a stock’s price movement.
Another benefit of options trading is that they are flexible. Trading rules and regulations change continuously, but the option contract stays the same no matter what fluctuation occurs in the market.
The purpose of options trading is to minimize risk and increase profit, which is why you should not take it lightly.
There are always risks involved with investing, but not understanding how to minimize those risks causes most issues. The most important thing about options trading is that the risk involved is known and controlled with knowledge.
Some of the risks include:
- Taxes – e.g. capital gains tax
- Commissions – higher than equities
- Lower liquidity – not a lot of volume with individual stocks
Options are usually considered to be riskier than futures contracts. This is because the owner of an option can lose more money than they originally invested.
Options and futures both hold their own sets of pros and cons, and traders should carefully consider these. Contact a reputable online broker, for example, one from Saxo Bank, for solid advice and trading on a demo account. Caveat emptor: Always seek professional financial advice before borrowing money for trading or investing.
Another article that may interest you is also on trading. Have you heard of a Quant Trader?
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