Why are futures more expensive than options?

The Price Differential Between Futures and Options Contracts

Futures contracts and options contracts are both derivative instruments, meaning their value is derived from the price of an underlying asset like a commodity, stock, or currency. However, a crucial difference in their inherent risk profiles significantly impacts their respective prices. While futures contracts offer the potential for substantial gains, they also carry the risk of unlimited losses, making them inherently more expensive compared to options contracts.

The key distinction lies in the nature of the obligation. A futures contract obligates both parties to either buy or sell the underlying asset at a predetermined price on a future date. This obligation creates a significant level of risk for both the buyer and seller, as the market value of the underlying asset could move significantly against their position. This uncertainty, along with the potential for substantial gains, drives up the price of a futures contract.

Options contracts, on the other hand, offer the buyer the right, but not the obligation, to buy or sell the underlying asset at a predetermined price (the strike price) on or before a specific date. This “right” is purchased for a premium, a fee paid to the seller of the option. Critically, the buyer’s potential loss is limited to the premium paid. If the price of the underlying asset doesn’t move favorably, the option simply expires worthless, incurring no further costs beyond the initial premium. This capped downside risk translates into a lower price for the option contract compared to the futures contract.

In essence, the premium paid for a futures contract reflects the buyer’s commitment to fulfil their obligation, whether the market price moves favorably or unfavorably. The premium for an option contract, on the other hand, compensates the seller for relinquishing their right to participate in the potential upside while limiting their risk to the premium received.

The difference in price between futures and options is a direct consequence of the varying risk profiles inherent to each instrument. Futures contracts, offering unlimited potential profits, are inherently riskier and command a higher price. Conversely, options, with their limited downside risk, are priced lower despite a potentially smaller profit ceiling. This fundamental difference in risk/reward dictates the relative valuation of these critical financial tools.