Options vs. futures: key differences and when to use each

Investing in the financial markets is a popular way for individuals and institutions to generate income and diversify their portfolios. Options and futures are two of the most commonly traded derivatives in Singapore, providing investors with opportunities to speculate on price movements without owning the underlying assets.

While both options and futures are used for similar purposes, they have significant differences that make them suitable for different investment strategies. This article will explore the main differences between options and futures trading in Singapore, how they can benefit traders, and when to use them.

Contract structure

The most fundamental difference between options and futures is their contract structure. Options contracts grant the holder the entitlement, yet not the responsibility, to purchase or sell an underlying asset at a preset price (strike price) on or before a fixed date (expiration date). On the other hand, futures are contracts that require both parties to buy or sell an asset at a predetermined price and date.

In options trading, the buyer pays a premium to the seller for the right to exercise the contract. In contrast, in futures trading, both parties must deposit a margin (a percentage of the contract value) as collateral. This difference in structure affects how investors manage their risk and potential profits. In options trading, investors can limit their losses to the premium paid, while in futures trading, they can face unlimited losses if the market moves against their position.

Underlying assets

Options and futures contracts have different underlying assets, contributing to their differences. FX options trading is widespread in Singapore, where investors can trade options on various currencies, including the Singapore dollar. In contrast, futures contracts in Singapore are mainly based on commodities such as gold, oil, and agricultural products.

The difference in underlying assets also affects how investors use options and futures. Options provide investors with a more diverse range of assets to trade and allow them to speculate on currency movements without owning the actual currency. Producers typically use futures trading to hedge against price changes, while speculators use them to profit from market movements.

It is worth noting that options are also available on futures contracts, providing investors with another layer of flexibility in their trading strategies.

Price determination

Price determination is another crucial difference between options and futures trading. The price of an options contract consists of two components: intrinsic value and time value. The intrinsic value is the difference between the current market price and the strike price, while the time value reflects the uncertainty of the underlying asset’s future price.

In contrast, futures contracts have a single predetermined price based on the current market value of the underlying asset. This difference in pricing can affect investors’ strategies as options allow them to profit from changes in intrinsic and time values. In contrast, futures only allow profits from changes in market prices.

Trading hours and expiration

Options and futures also differ in their trading hours and expiration dates. FX options are traded on exchanges, giving investors fixed trading hours to buy or sell contracts. The expiration date of an options contract is predetermined, and investors must exercise the option before this date to realise profits. Futures, on the other hand, can be traded almost 24 hours a day and have various expiration dates depending on the underlying asset.

The difference in trading hours and expiration affects investors’ strategies as options traders must carefully time their trades to take advantage of market movements. In contrast, futures traders can enter and exit positions more flexibly but must monitor their contracts’ expiration dates closely.

Traders can also roll over their futures contracts before expiration, extending the trade’s duration. This feature is not available in options trading. It is essential to understand these differences when deciding between options and futures for investment purposes.

Leverage and margin requirements

Options and futures also have different leverage and margin requirements. As options contracts are for the right, not the obligation, to buy or sell an asset, they require less margin than futures contracts. Therefore, investors can control a more prominent position with a smaller initial investment in options trading.

In contrast, futures contracts require higher margin requirements due to their obligation to buy or sell the underlying asset. This difference in leverage and margin requirements can affect investors’ risk management strategies as options trading allows for more leveraged positions with potentially lower risks.

Liquidity

Options and futures differ in liquidity, influencing their pricing and trading strategies. Options contracts are generally less liquid than futures as they are traded on exchanges with a limited number of participants. It can result in wider bid-ask spreads and potentially higher costs for investors.

In contrast, futures contracts are highly liquid due to their standardised nature. They are traded on exchanges with many participants, allowing for more efficient price discovery and potentially lowering investor costs. However, the high futures liquidity can also result in higher volatility and risks.