7

As a form of investment there are contracts to buy commodities at a specific time in the future or at a specific price. How is this different from an option to buy a share?

10

Cart's answer is basically correct, but I'd like to elaborate:

A futures contract obligates both the buyer of a contract and the seller of a contract to conduct the underlying transaction (settle) at the agreed-upon future date and price written into the contract.

Aside from settlement, the only other way either party can get out of the transaction is to initiate a closing transaction, which means: The party that sold the contract buys back another similar contract to close his position. The party that bought the contract can sell the contract on to somebody else.

Whereas, an option contract provides the buyer of the option with the choice of completing the transaction. Because it's a choice, the buyer can choose to walk away from the transaction if the option exercise price is not attractive relative to the underlying stock price at the date written into the contract. When an option buyer walks away, the option is said to have expired.

However – and this is the part I think needs elaboration – the original seller (writer) of the option contract doesn't have a choice. If a buyer chooses to exercise the option contract the seller wrote, the seller is obligated to conduct the transaction. In such a case, the seller's option contract is said to have been assigned. Only if the buyer chooses not to exercise does the seller's obligation go away. Before the option expires, the option seller can close their position by initiating a closing transaction. But, the seller can't simply walk away like the option buyer can.

  • You are absolutely correct Chris. Thanks for the additional comments. – Cart Nov 24 '09 at 15:44
4

For futures, you are obligated to puchase the security at $x when the contract expires. For an option, you have the right or option to do so if it's favorable to you.

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