What are futures?
Futures are financial contracts that obligate the buyer to purchase an asset or the seller to sell an asset at a predetermined price and date in the future. They are used to hedge against price fluctuations or to speculate on the future price of an asset. Commodities, currencies, and financial instruments such as stocks and bonds can all be traded using futures contracts. They are traded on organized exchanges, and are settled either in cash or with physical delivery of the underlying asset.
What are Options?
Options are financial contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and date in the future. They are similar to futures in that they are used to hedge against price fluctuations or to speculate on the future price of an asset. However, unlike futures, the holder of an options contract is not obligated to exercise the option and can choose to let it expire if it is not profitable.
Options contracts come in two types: call options and put options. A call option gives the holder the right to buy an asset at a certain price, while a put option gives the holder the right to sell an asset at a certain price. The price at which the option can be exercised is known as the strike price.
Options are also traded on organized exchanges and are settled either in cash or with physical delivery of the underlying asset
An example of an options trade
A trader believes that the price of XYZ stock will increase in the next month. He buys a call option on XYZ stock with a strike price of $50 and an expiration date one month from today. The option costs $2 per share.
If the price of XYZ stock increases to $60 by the expiration date, the trader can exercise the option and buy the stock at $50, and then sell it at the current market price of $60, making a profit of $8 per share. If the price of XYZ stock does not increase to $60, the trader can let the option expire worthless and lose only the $2 per share that he paid for the option.
An example of a future trade
A farmer grows corn and wants to protect the price of his harvest, which is due in three months. He sells a futures contract on corn with a delivery date in three months. The contract is for 5,000 bushels of corn and the current price is $4 per bushel.
If the price of corn falls to $3 per bushel by the time the contract expires, the farmer is still obligated to sell his 5,000 bushels at $4 per bushel. So, he has protected his profit by locking in a price that is higher than the current market price. If the price of corn increases to $5 per bushel, the farmer will have missed out on the higher price, but still locked in a profit.