Differentiating a Stock Option with a Stock Future
In a nutshell, a stock option is a financial instrument which signifies a contract between two parties that represents a transaction in the future for an asset at a price, or also known as a strike price. Basically the buyer receives the right to participate in the transaction but not the obligation to do so. On the other hand, the seller incurs the obligation for the transaction to be completed.
A future on the other hand is a contract that denotes purchase of a particular asset at the price it is right now. One easy way to understand this is to look at a tangible example. Say that you own a company that sells ham sandwiches. This means you will need a steady supply of ham from a supplier. Of course, you would want to purchase your raw material at the lowest price possible to maximize profits. However, you will notice that the price of ham today might be different in a year. In this situation, you can enter into a futures contract with your supplier promising to buy a certain amount of ham for the entire year at a fixed price (no matter what happens to the price in the market).
This benefits both sides since you get to purchase supplies at a price you are comfortable at. It becomes stable. It also benefits the supplier since they need to keep selling and this guarantees them those sales.
Now that both financial instruments have been defined, you will notice that the fundamental difference between options and futures is the obligation. As mentioned earlier, an option provides the buyer the right, but not the obligation to buy or sell the mentioned asset at a predefined price within the lifetime of the contract. Trademonster is one of the few brokers that has low fees for options traders, at http://bestratesin.com/trademonster/888/ you can read the full tradeMonster review that includes its advantages and drawbacks.
On the other hand, a future contract provides the buyer an obligation to make a purchase a defined asset from the seller at a predefined price. The seller has the obligation to deliver the asset as defined by the contract.
Another key difference between a future contract and an option contract is the underlying position. In general, the underlying position of future contracts are much larger compared to option contracts. Plus, the obligation to buy or sell of a particular asset at a certain amount as defined in future contracts make it much riskier as compared to option contracts as well. This makes it less recommended for new and inexperienced investors.
The final difference between future and option contracts is the method of how the gains are received from each by the parties involved. With an option, the gain can be realized in one of three ways:
1. The investor exercises the option when the strike price of the asset is lower than it is in the market; thus gaining more for less.
2. The investor can also go into the market and take the opposite position to make a gain.
3. Last, the investor can wait it out and let the contract expire in order to collect on the difference between the price of the asset and the strike price defined in the contract.
For future contracts on the other hand, the gains are actually automatically marked to market on a daily basis. This means that the change in the value of both positions would be attributed to the parties’ accounts at the end of each and every trading day. Another good broker that comes to mind is OptionsXpress, you can read the entire review at http://bestratesin.com/optionsxpress/774/ which specifies the pros and cons of trading with them.
On top of that, similar with options, an investor can also gain from future contracts by going to the market and take the opposite position.
On the surface, futures and options may look a bit the same. But these small factors show you that they are extremely different especially on how to handle and profit from them.