Introduction
Financial derivatives can be described as futures, options, swaps, or other hybrid assets that have no independent value. Its value is determined by the underlying securities, commodities and currency. Many people misunderstand options and futures in this context. The legally binding contract to trade the financial asset at a specified price at a future date may be called a futures contract.
An options contract, on the other hand, is a choice that the investor can make. An option contract is a contract that allows the investor to make a decision about buying or selling a financial product at a specified price before the time expires. To understand the difference between futures and options, take a look at the article.
India's equity derivatives market is larger than Indian equities. There are two main types of derivatives: Futures and Options. Both have their own features. In this article, we will discuss the main difference between futures and options. Let's first discuss the basics of options and futures trading before we get into the details.
Difference Between Futures and Options in Tabular Form
| Basis For Comparison | Futures | Options |
| Significance | Futures contracts are a binding agreement that allows you to buy and sell a financial instrument at a specified price at a future date. | Options are a contract that allows the investor to purchase or sell a financial instrument at a fixed price on or before a specific date. However, they are not required to do so. |
| Buyer's obligation | Yes, you can execute the contract. | There is no obligation. |
|
Execution | At the agreed time. | Anytime prior to the expiry date. |
| Risques | High | Limited |
| Advance payment | There is no advance payment | Premiums are paid. |
| Gradual profit/loss | Unlimitable | Profitable without limit. |
What is Futures?
Futures trading requires that the investor sell or purchase the stocks or shares in the future at a certain date. Future trading prices determine the price at which assets will be traded. A seller might want to sell assets at a reasonable price in advance in case future market prices drop. If future prices rise, the buyer may also want to lock in a price upfront. Futures trading is a way to profit whether the price goes up or down. Future contracts are just like any other financial product. Investors should be aware of the risks associated with futures contracts and make appropriate investments.
Definition of Future Contract
Future can be defined as a contract between buyer and seller in which both parties agree to buy or sell the financial asset at a specific price and date in the future. The contract is legally binding and the parties must execute it by cash/stock transfer.
Futures contracts are standardized and transferable contracts that revolve around four key elements. Transaction date, price and buyer are the four key elements of a futures contract. Future contracts will include currency, stocks, and similar financial assets that are traded on stock exchanges like NYSE, NASDAQ, BSE, or NSE. These contracts are where the buyer and seller both expect the asset's price to rise while the other expects it to fall.
What are the Options?
Options are valued based on an underlying asset. Contrary to options trading, investors are not required to purchase or sell assets at a certain price prior to the expiration of the contract. The investors can either buy or sell the asset depending on their will. Options are a form of derivative investment.
Definition of an Option Contract
A derivative that is exchange-traded, where the financial asset holder has the right to purchase or sell securities at a specified price on or before a given date, is considered an option. The strike price is the predetermined price at which trading will be completed. You can purchase the option by paying an upfront fee, also known as premium, that is non-refundable.
Optional means that you can buy the underlying asset. The put option is for selling the asset. Both buyers have the option to exercise the option, but they are not required to.
Let's look at the difference between options and futures.
Futures vs. Options
Futures and Options allow investors to purchase or sell assets in the future at a set price and date. While both options and futures work in the same way, they have different parameters. Below is a breakdown of the differences between options and futures.
- Future trading, as mentioned previously, is subject to an obligation to conclude the agreement and trade in future at a fixed price and date. Options trading allows the investor to trade or cancel the agreement at any moment before the expiration of the contract.
- Future trading has a higher risk than Options trading. Options trading has a lower risk than options because the premium is only.
- Future contracts do not require advance payment. In options trading, you will need to pay a premium upfront before activating the contract.
- The future is open to both profits and losses. Options have low losses and high profits.
- Future trading is a situation in which the investor is required to purchase or buy an asset in the future at a specific date. There is no time factor. Options however require that the trader decide before the contract expires. Options have a time factor that is critical.
Let's look at an example to show you the difference between futures and options.
Example of Futures Trading
Let's say there are two investors interested in investing in an IT stock company. Investor A currently holds Rs 900 worth of stock in the IT company. Investor A believes that the stock price will drop in the coming weeks to Rs870.
Investor B, on the other hand, believes that the stock will continue to boom as the company launches a new product. Investor B has analyzed the market and believes that the stock will rise to Rs. 950 over the next few weeks.
Both investors enter a futures contract that lasts for 1 month. Investor A will not exercise the futures contract if stock prices rise above Rs 900. This will result in investor B receiving profits. Investor A will also be profitable if prices fall.
Option Trading Example
Let's say a stock is currently trading at Rs550. An investor has the option to purchase the stock at Rs600. This is because the stock's value is greater than Rs. 600 in the future.
This stock is available for purchase at Rs. 600, whose market value is significantly higher than that. Options trading is an option in this situation. To initiate the contract, you will need to pay an Rs10 non-refundable premium.
Options and Futures work in different ways, but their basic purpose is the same. They try to make a profit by stock without actually investing any money.
Price, liquidity, and value
Futures contracts can be used to trade commodities. They are as close as you can get to trading the actual commodity without trading it. These contracts are more liquid than options contracts. Futures contracts are more suitable for day trading. Futures contracts are more flexible than options and have less slippage. They also move faster so it's easier to trade them.
Because options are only linked to futures contracts, options contracts move faster than futures contracts. Futures contracts move quicker than options contracts. This could be as high as 50% for at-the-money options, or as low as 10% for deep out-of-the-money ones. There is no need to be concerned about options' constant time decay in value.
Futures options can be a wasteful asset. Options lose value every day. This is known as time decay and tends to increase with options getting closer to expiration. It can be frustrating when you are right about the direction of a trade, but your options end up worthless because the market hasn't moved far enough to offset time decay.
What are some Futures and Options Strategies for Investors?
Options contracts are a popular choice for new commodity traders. Options contracts are attractive because you don't have to lose more than what you invest. Options trading can be more conservative, especially if you use option spreading strategies.
If you are looking for a long-term trade, bear call spreads or bull put spreads may be more profitable than if the first leg is in the money.
Spread strategies are popular among professional traders, particularly in the grain markets. Spreads are easier to trade, such as buying and selling front- and distant-month contracts against one another. Also, you can spread different commodities like wheat and corn.
The time decay of options can be a disadvantage, but it can also work in your favour if you have an option selling strategy. To take advantage of the fact many options are worthless, some traders only sell options. Although you can take unlimited risks when selling options, the odds of making a profit on every trade are higher than buying options.
Options traders love the slower movement of futures contracts. A single wild swing can quickly cause you to be stopped from a futures trade. You have many options and your risk is minimal. Options can be safer if the market reaches its target within the timeframe.
Learn More about Futures Options
You have two options when it comes to trading options: you can choose between a long or a short position depending on the direction that which prices are moving.
Shorter options are safer than long options. The premium you paid to purchase an option is all that is at stake. Options are price insurance, they ensure a certain price level (called the strike price) for the buyer.
Traders refer to the price for an option as the premium. They borrow the term from an insurance company. The option seller would collect the premium and the option buyer would pay the premium. An option seller is more like an insurer, while an option buyer is more like an insured consumer. The premium paid is the maximum profit you can make selling or granting an optional. The premiums paid by the customers of insurance are the only way an insurance company can make money.
Key differenced between futures and options in points
Below are the key difference between futures and options.
- A Futures Contract is a binding agreement that allows the buyer or seller to buy or sell a financial instrument at a fixed price at a specified future date. An Options Contract is a contract that allows the investor to purchase or sell the financial instrument at a predetermined price on or before a specific date. However, the investor is not required to do so.
- The buyer is bound to honour the contract by futures contracts. In contrast, the options contract gives the buyer the option of selling or buying the security.
- Future performance is at the specified date. Options allow for performance at any time prior to the expiry date.
- Futures are riskier than options.
- Futures require no advance payment other than the commission. Options require payment of a premium.
- Future earnings/losses can be unlimited. Options profits are limited to a set amount.
Similarities Between Future and Options
Futures and Options are both exchange-traded derivative contracts. They are traded on stock exchanges such as the Bombay Stock Exchange or National Stock Exchange (NSE), which are subject to daily settlement. These contracts cover financial products like stocks, currencies, bonds and commodities as the underlying asset. Both contracts also require a margin account.
Conclusion
After a detailed discussion of the investment topics and the difference between futures and options, we can conclude that there is no misinterpretation between them. Options come with an option (choice), while futures have no options, but they can perform and execute as well.
Commodities can be volatile assets for many reasons. Because the price of the commodity will be followed, this means volatility in futures and options. Variability or volatility in the underlying market determines the price of an option.
Your risk profile, time horizon and opinion on the direction and volatility of the market will all influence your decision to trade options or futures.
