Futures, options and forward contracts belong to a group of financial securities known as derivatives. The profit or loss resulting from trading such securities is directly related to, or derived from, another asset, such as a stock. There are, however, crucial differences between these three derivative securities, which you should understand before investing in them.
What Are Options?
An option gives the holder the right – but not the obligation – to buy or sell an asset at a specific price on a specific date. A call option represents the right to buy, while a put option represents the right to sell.
A call option on 1,000 shares with a strike price of $100 and an expiration date of Aug. 27 allows the option holder to buy 1,000 shares at $100 each on Aug. 27. If the market price of the stock is $110 per share, it makes sense to exercise this privilege, because you can then sell the same shares at $110 for an immediate profit. If the stock can otherwise be purchased for $90, however, the holder would not exercise the call – hence the name "option."
Basics of Forward Contracts
Forward contracts are binding agreements to buy or sell an asset at a specific price on a specific date. For example, two parties may agree to trade 1,000 ounces of gold at $1,200 per ounce on Sept. 1. One party to such an agreement will have an obligation to buy, and the other will have an obligation to sell.
Such contracts can involve practically anything of value, including stocks, bonds, foreign currencies, agricultural commodities such as corn or soybeans, and valuable metals, including gold and silver. The asset that changes hands is referred to as the underlying asset, or simply "the underlying." Forwards are traded over the counter.
How Futures Contracts Work
A futures contract is simply a standardized forward agreement. If you are a cereal manufacturer and buy a lot of corn, it would be time-consuming to negotiate a different forward contract with every corn farmer. To streamline the process, large commodities exchanges offer standardized agreements through which corn, for example, is traded in increments of 1,000 bushels on specific dates.
The specifications of corn to be delivered are also set. That way, the buyer and seller can select one of the standard contracts, changing only the quantity as suits their needs.
Key Differences Between Them
The major difference between an option and forwards or futures is that the option holder has no obligation to trade, whereas both futures and forwards are legally binding agreements. Also, futures differ from forwards in that they are standardized and the parties meet through an open public exchange, while futures are private agreements between two parties and their terms are therefore not public. Options can be standardized and traded through an exchange or they can be privately bought or sold, with terms crafted to suit the needs of the parties involved.
Another key difference is that you must always pay money to buy an option because having the choice to exercise the option is a privilege. When entering a forward or futures agreement, however, you pay nothing at the time of the agreement. You place yourself under an obligation to either buy or sell on the expiration date.