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While futures offer price protection by allowing the holder of a futures contract to lock in a price level, a major appeal of options is that the holder of an options contract is afforded price protection, but still has the ability to participate in favorable market moves. Because the buyer of an options contract has the options contract but not the obligation to perform, he incurs no expenses beyond the initial premium. Therefore, if the market moves against a position, and a trader holds on to this option, the maximum cost is the price he has already paid for the option.

On the other hand, if the market moves in favor of a position, the virtually unlimited profit potential to the buyer of an options contract is parallel to a futures position, net of the premium paid for the options contract. Therefore, protection from unfavorable market moves is achieved at a known cost, without giving up the ability to participate in favorable market moves.

Futures vs. Options
Futures
Options
Risk
Unlimited risk on long and short positions Defined and limited on purchases of puts and calls; unlimited on sale
Price Protection
Establishes fixed price Establishes floor or ceiling price protection
Margin
Required on long or short positions Futures style margins for sellers, margin contained in the cost of premium for buyers
Hedging
Long, short, spread Multiple hedging strategies

For example, an oil refiner buying crude oil is exposed to the risk of rising crude prices, and benefits when raw material prices decline. The less costly the crude, the lower the manufacturing costs will be. In order to protect against crude oil cost increases, the refiner can either buy a crude oil futures contract or buy a crude oil call options contract.

Assume that the crude market is trading at $27 a barrel, but the refiner fears that prices may increase for his crude oil requirements in the next quarter. He could buy $27 calls for each of the three months involved for 70 a barrel, or $700 per contract (each contract is for 1,000 barrels), plus transaction costs.

If the price climbs to $30 per barrel, the refiner has earned $3,000 per contract ($3 per barrel on 1,000 barrels), less the $700 premium he paid for the call, for a net gain of $2,300. This gain would offset $2.30 of the $3-a-barrel increase in his cash crude costs.

What if crude oil prices fall? Because the holder of an options contract has a right and not an obligation, if price of crude oil falls to $25 per barrel, the refiner would let the options contract expire and buy his cash crude oil requirements at the lower, more favorable market price.

For comparison, assume that the refiner hedges his position only with futures. He buys crude oil futures at $27 and the market rises to $30. In that case, his profit on the futures position (excluding transaction costs) would be $3,000 or $3 per barrel, which would fully offset the increase in his cash crude costs. However, if the price falls to $25 per barrel, the refiner would have locked in his cost at $27 per barrel and forfeited the lower, more favorable market price.

The futures-only position gives him a stable oil acquisition cost $27 no matter which way prices move, at the cost of forfeiting the ability to participate in a decline in his raw material prices.

Likewise, a jewelry manufacturer who uses gold is exposed to the risk of rising metals prices, and benefits when gold prices decline. In order to protect against cost increases, the manufacturer can either buy a gold futures contract or buy a gold call options contract.

Assume that gold is trading at $265 an ounce, but the manufacturer fears that prices may increase for his requirements over the next six months. He could buy $265 call options for the six months for a premium of $4.00 an ounce, or $400 per contract (each contract is for 100 troy ounces), plus transaction costs.

If the price climbs to $285 per ounce, the jewelry company has earned $2,000 per contract ($20 per ounce on 100 ounces), less the $400 it paid for the call options contract, for a net gain of $1,600. This gain would offset $16.00 per ounce of the $20 increase in his cash costs.

Suppose gold prices then fall. Because the holder of an options contract has a right and not an obligation, if the price of gold falls to $250 per ounce, the jewelry company would let the options contract expire and purchase its cash gold requirements at the lower, more favorable market price.

Assume that the jewelry manufacturer hedges his position only with futures. He buys gold futures at $265 and the market rises to $285. In that case, his profit on the futures position (excluding transaction costs) would be $2,000 or $20 per ounce, which would fully offset the increase in his cash costs. However, if the price falls to $250 per ounce, the jewelry manufacturer would have locked in his cost at $265 per ounce, and forfeited the lower, more favorable market price.

The futures-only position gives him a stable gold acquisition cost $265 no matter which way prices move, at the cost of forfeiting the ability to participate in a decline in his raw material prices.

While the loss that can be incurred on an options contract is limited to the premium, the loss that can be incurred on a futures contract is the opportunity cost resulting from locking in a price and forfeiting the benefits of favorable market moves.

Although options and futures are by necessity closely related, they are not interchangeable. Each has advantages and disadvantages and can be used separately or in combination to achieve a variety of risk management and investment objectives.

  

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