Trading options futures compared
Trading options in Australia used to require contract sizes of 1, shares. In , trading one options contract now controls 1, BHP shares for example. Liquidity, in this case, means the number of buyers and sellers present at any one time. The more buyers and sellers, the easier it is to transact at your preferred price. When there are fewer buyers and sellers, it means you have an illiquid market.
Illiquid markets are difficult to buy and sell at your preferred price. CFDs provide the ability to trade both long and short with ease. For Short Selling , you open the position by selling it first. To close it, you buy it back. There are no complicated rules to follow or different instruments to choose. CFDs are simple to understand and trade. CFDs are derivatives, which are sophisticated trading products and you must know the risks involved before you start trading.
Option pricing is quite complex and not for the faint-hearted. It is critical for CFD traders to manage their risk to ensure their survival. It is impossible to say whether CFDs are the right instrument for you to trade. They are both financial contracts that exist between two parties — the buyer and seller of an underlying asset.
They can both be traded on public exchanges, although some of the more complex contracts are only sold over the counter. They are also both leveraged derivatives — although if you know what this means the chances are that you can already recognize the difference between the two.
Basically, a derivative is a financial instrument that derives its value primarily from one or more underlying asset. Leverage is a term for any technique that you use to effectively multiply the power of your capital. For example, if you buy stocks in a company then you physically own a share in that company and the asset you own can go up or down in value.
When buying a derivative, you are buying a contract which is valued according to the underlying asset on which it's based and possibly other factors such as the length of the contract. Leverage is when you effectively multiply the power of the cash you are investing to generate larger returns; this is possible with both options and futures and is the main reason why they are known as leverage derivatives.
The fundamental difference between options and futures is in the obligations of the parties involved. The holder of an options contract has the right to buy the underlying asset at a fixed price, but not the obligation.
The writer, or seller, of the contract is obligated to sell the holder the underlying security or buy it , if the holder does choose to exercise their option. This obviously puts the holder of a contract at an advantage, because if the underlying security moves against them, they can simply let the contract expire and not incur any losses over and above the original cost.
If the underlying security moves in the right direction for the holder and therefore against the writer , then the writer must honor their obligation. In a futures contract, both parties are obliged to fulfill the terms of the contract at the point of expiration. This is a very significant difference. Buying a futures contract where you will be obliged to buy a particular security at a fixed price carries much more risk than buying an options contract where you have the right to buy a particular security at a fixed price, but are not obliged to go through with it if that security fails to move up in value as you expect.
Both parties involved in a futures contract are effectively exposed to unlimited liability. The costs involved are also different. When an options contract is first written, the writer of it sells it to the buyer and receives the money that the buyer pays. Depending on the terms of the contract, the underlying security involved, and the circumstances of the writer, the writer may have to have a certain amount of margin on hand.
They may also be required to top up that margin if the underlying security moves against them. However, the buyer owns those contracts outright and no further funds will be required from them. With futures, though, as both parties are exposed to losses depending on which way the price of the underlying security moves, they are both required to have a certain amount of margin on hand. Price differences on futures are settled daily, and either party could be subject to a margin call if the value of the underlying security has moved against them.
This contributes largely to why futures trading is generally considered riskier than options trading. Below we look at a couple of the advantages trading options has to offer.