What Is the Biggest Difference Between an Option & a Futures Contract?
The two most common securities are stocks and bonds. However, there are also are other securities out there that are not as well-known. Two of those securities are futures and option contracts. The contracts do have similar characteristics but there is one big difference between the two that affects the pricing of the contracts.
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Option Contract
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An option contract gives the purchaser the right to buy or sell short 100 shares of the underlying security. The underlying security can either be a stock or exchange traded fund. There are two types of options: puts and calls. The call gives the right to the owner to purchase shares while the put gives the right to the owner to sell shares short. The contract can be exercised at any time before the expiration date. An option contract is usually quoted by the exercise price and the date of the expiration. Option contracts expire on the third Friday of the expiration month. It only makes sense to exercise the option contract if the price of the underlying security is higher than the exercise price on a call option or lower than the exercise price on a put option.
Futures Contract
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A futures contract is an obligation for delivery or purchase of the underlying security. Futures contracts usually cover such securities as commodities, currencies, interest rates and stock market levels. Because the contracts are traded on such a wide scale, they are standardized for the key factors, such as price, quantity and delivery date.
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Difference
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The biggest difference is that an option gives the owner the right to buy or sell short while a futures contract is an obligation for the transaction. For example, if you own a call, you have the choice of exercising it before the expiration date. If you bought a futures contract, you have an obligation to purchase the underlying product at the price specified on the date specified.
Use
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Although there are people that trade futures contracts for profit, the primary use of option and futures contracts are for hedging purposes. For example, let us say that a company needs 100 barrels of oil for delivery in two months. However, in between that time, the price of oil could fluctuate wildly and rise or fall. A fall would be a good thing, but if the price rises, then the company may not be able to afford it. By locking in the price of oil today, the company hedges away the price risk of oil and knows exactly what it will pay for 100 barrels of oil two months from now.
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