FAQ: Futures, Options & Tropic Thunder II

Q: Aren’t options spreads cheaper to trade than futures spreads?

A: This question is based on a misunderstanding of the mechanics of futures and options trading.

Options:

With options, including options on futures, you pay a “premium” when you buy an option and receive the “premium” when you sell an option.

If you pay 10 cents for an option, that 10 cents is debited from your trading account. If you sell an option for 15 cents, that 15 cents is credited to your account.

Taking the example further, suppose these two options make up a spread. That is, you buy one option for 10 cents and sell a different option for 15 cents. The net amount (5 cents) is credited to your account.


Futures:

For futures contracts, it’s different. The price paid or received in a transaction is not actually debited or credited from/to your account. All that applies is a margin deposit. This goes for both single positions and spreads.

For example, suppose we have Dec Wheat at 450 and March Wheat at 470.

If you buy Dec Wheat at 450, you don’t actually fork out the contract value of 450 cents per bushel. Likewise if you sell short the March contract at 470, you do not receive 470 cents per bushel in your hand.

With futures you are entering into an agreement to buy or sell. You do not pay the full amount. You are instead subject to a small margin deposit.

Let’s take the example further. Suppose you enter into a spread whereby you buy the Dec contract at 450 and sell the March contract at 470. The ‘spread price’ is therefore a credit of 20 cents. That credit is not credited to your account. The futures contracts are just agreements, not a transaction where the net debit/credit is transferred.


An Analogy:

Hmmm, I don’t want to confuse the issue here, but here is an analogy. Suppose you are on the way home from work and pass the local Virgin Megastore. You see Tropic Thunder II: Grossman’s Revenge is coming out on DvD next week and you want to make sure you get the first copy.

Unfortunately you do not have the full $20 in your pocket to prepay the entire cost of the DvD, but the store manager offers you one of two deals.

Deal 1 – The manager says if you pay him a $1 non-refundable deposit now, you have the right to come back any time this month and pay $20 for the DvD. Even if the price rises, all you pay to buy the DvD is $20, plus the original $1 . You don’t have to come back to buy the DvD, but if you don’t, you lose the $1.

Deal 2 – The manager says if pay him a $1 deposit now on the promise you will come back and buy the DvD, he says the deposit is refundable against the purchase price, but you must make the purchase.

Deal 1 is an Options Contract and the $1 is the premium paid; Deal 2 is a Futures Contract and the $1 deposit is a Margin.

The difference between the two is not only a right (option) versus an obligation (futures), but the flow of funds. Deal 1 (the option) was a payment whereas Deal 2 (the futures) was a deposit.

This analogy is not perfect, but it does get the point across.

Note that for both futures and futures options, relevant margins and mark to market adjustments also apply, but that’s another conversation.