Many new traders have a hard time figuring out whether they want to enter a trade using a futures contract or by purchasing an option. Some like the potential futures offer while others like the limited risk that comes with purchasing a call or a put option. This article will explain the two and help you to figure out what scenarios might be more appropriate for trading a futures contract and buying an option.
A futures contract is an agreement to buy or sell a particular commodity in the future at a pre-determined price. If you think the price of a commodity is going to rise, you would want to buy a futures contract. If you think it will fall, you would want to sell a futures contract. You can sell-or ‘short’–a market just as easy as you can buy–or go ‘long’–a market. A futures contract can be appropriate for most trading scenarios. It is good for swing tradingholding a position overnightas well as day trading; that is, getting in and out of a position during the same trading day. However, a futures contract might not be appropriate when there is a market report coming out. An example of this is the monthly Crop Production report. This report can really move markets and does at times result in limit moves. A limit move is a predetermined limit that a market can move in a single trading day. For corn, the limit is 30 cents. A 30 cent move in corn is a $1,500 move. If that is too much risk for you in a single day, buying an option can be a viable alternative.
An option is the right, not the obligation, to buy or sell a futures contract at a designated price. Purchasing a call gives you the right to buy a futures contract at a designated price. Purchasing a put gives you the right to sell a futures contract at a designated price. To learn more about purchasing options, read my previous article: Options on Futures: An Introduction to Buying Options. One of the beautiful things about purchasing options is that your risk is limited to what you paid for the option. A futures contract, on the other hand, has unlimited risk. If you are not comfortable with the unlimited risk that is associated with futures, purchasing an option would be more appropriate for you. As discussed above, purchasing an option may also be an attractive alternative to a futures contract when a market report is about to be released. You can have a position in a potentially volatile market while having the comfort that comes with limited risk. One scenario that may not benefit an option purchaser is the fact that an option is a wasting asset. If the call or put you purchased is just one tick out of the money, it will expire worthless and all of the premium paid will be lost.
These are just a few of the scenarios that many traders face when trying to decide on whether to use a futures contract or purchase an option to enter a trade. Both futures and options have their advantages and disadvantages under certain scenarios. If you decide to use a futures contract in your live account, paper trade the option to see how it differs. This will help you to figure out what style is appropriate for you risk tolerance and trading philosophy.
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Paper Trading Risk Disclosure: BEING A SUCCESSFUL PAPER TRADER DURING ONE TIME PERIOD DOES NOT MEAN THAT YOU WILL MAKE MONEY WHEN YOU ACTUALLY INVEST DURING A LATER TIME PERIOD. MARKET CONDITIONS CONSTANTLY CHANGE.
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About Drew Wilkins
[...] people are just too laid-back that they think that options trading is something simple, something just about anyone off the street can do. The truth is, it is not. [...]