Both futures and options belong to a broad category of financial products known as financial derivatives. The value of a derivative contract depends on, or is derived from, the price of another financial asset. Futures and options can be valuable additions to a diversified portfolio. They differ significantly, however, in terms of their risk and reward profiles. You should thoroughly understand these instruments before investing in them.
Understanding Futures Contracts
A futures contract is a legally binding agreement between two parties to trade a specific quantity of a particular asset at a fixed price and date. While a futures contract can lock in a price for any asset, currencies, stocks and bonds are most frequently exchanged using futures.
A typical futures contract might be to exchange euros for dollars; parties may agree to exchange 1,000 euros for $1,100 on Feb. 5, for example. When working with currencies, the terms "buyer" and "seller" can be confusing. In this example, both parties are buyers, since one will buy euros and the other will buy dollars. Both are also sellers. Therefore, do not use the terms "buyer" or "seller" without defining what is being sold or bought.
Understanding Currency Options
A currency option gives the holder the right, but not the obligation, to exchange one currency for another on a future date. The options contract will specify which currency the option holder will submit and which she will receive, as well as the quantities of each currency to submit and receive. The option may give the holder the ability to hand in 1,000 euros and receive $1,100 in return on Feb. 5, for example.
If, however, one can buy more than $1,100 with 1,000 euros on Feb. 5 in the financial markets, the option holder has the right to simply ignore the option contract and exchange euros for dollars at the more favorable market rates. This is called "letting the option expire."
Upfront Payment vs Free Initiation
When signing a futures contract, no money is exchanged between the parties. This is because they merely sign a fair agreement to make a future trade. Options, however, are not designed to be fair but to put one party in a privileged position. The option holder purchases the privilege to trade if she so desires or to ignore the locked-in price if doing so is more advantageous. Therefore, the person buying the option makes an upfront payment. One difference between futures and options is the initial payment you must put up in an option trade -- in addition to the currency you will deliver later.
Limited vs Unlimited Risk
The worst that can happen when you buy an option is the loss of the upfront payment. If you don't like the locked-in price when the trading date arrives, you can simply ignore the option. However, you can lose immense sums in a futures trade. The price locked in by the futures contract can force you to buy a currency at very high prevailing rates and sell very low.
Assume, for example, you signed a futures contract to give 1,000 euros and receive $1,100 even though you had no euros at hand, and on Feb. 5, one euro equals $2. Now, you must pay $2,000 to buy 1,000 Euros, which you will then give to the other party and get $1,100 in return. You will lose $900 in this transaction.
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