What are Futures and Options? (Using technical analysis)

‘Futures’ are an agreed upon sell date for a quantity of a particular commodity at a particular time. ‘Options’ are similar to a ‘futures’ contract, with the exception that a buyer is not obligated to act on the terms of the initial agreement, but still retains the right to do so if he chooses.

New investors should be aware that there are also ‘futures options’ and ‘futures contracts,’ which are two distinct entities. To use traditional terminology, futures options are essentially options, and futures contracts are essentially futures. Because this terminology can be used interchangeably, it’s a good idea to be aware how these concepts are described when first entering into the trading market.

Futures are slightly riskier than options, primarily because futures require an action, whereas options allow for more equivocation and adjustment to current market trends. Naturally, the greater risk involved, the higher the potential return, or conversely, the greater the potential loss.

It should be noted that buying options usually incurs a premium, which is the fee that the trader earns from the transaction. This premium is based on the relative riskiness of the transaction. Those transactions that will almost certainly prove to be profitable carry a correspondingly high premium; those that are likely to fail will usually have a lower premium. Options are usually classified into ‘calls’ and ‘puts.’ A call option indicates that an investor believes a particular commodity will rise in value over a set period of time. A put option, on the other hand, indicates that the investor feels that the commodity will lower in value over a set period of time. In either case, a ‘strike price’ is set at the time of the purchase of the option. The investor has the choice of closing or converting the option before the set expiration date. Many investors choose to allow their options to close, instead of converting them. They then collect the subsequent profit.

Futures, on the other hand, are less flexible. Both the buyer and the seller must provide the agreed commodity at the pre-agreed price, regardless of market changes or fluctuations. If 6,000 bushels of wheat are promised at $5 per bushel over a year period, the terms can’t change until the futures contract is fulfilled. These two positions are usually known as the ‘short’ and the ‘long’ position. The short position is held by the provider of the commodity; the long position is held by the receiver of the commodity. A futures contract is valued against the actual performance of the market, and settled in cash at the end of each trading day.

As an example, if the short position agrees to provide the wheat at $5 a bushel, but the price of wheat on the market changes to $6, the short position has just lost a dollar on each bushel of wheat compared to what he could earn on the open market, while the long position has just saved a dollar on each bushel of wheat compared to what he could buy it for on the open market. At the end of each trading day, each party will either have their account debited or credited depending on the performance of the market until the futures contract expires.

However, the bulk of futures contracts do not involve the actual delivery of tangible items, but rather provide a means of taking a financial position on a potential transaction. For many commodities, depending on the position that the investor adopts and the subsequent performance of the market, futures contracts are an excellent way of guaranteeing a source of income.