Difference Between Futures and Options
Difference Between Futures and Options
Stock market is a volatile place especially when it comes to futures and options trading where traders buy and sell stocks, bonds, currencies and commodities on a regular basis. To safeguard themselves from volatility, traders resolve derivatives. Derivatives are financial instruments that derive their value from underlying assets which can be anything bonds, stocks or commodities.
Futures and options are two types of derivative contracts that are often used to hedge risk or speculate on the future price of an underlying asset. But is there a difference between the two? In this article, we'll take a closer look at both futures and options, and explain how they work.
What are Futures?
Futures contracts are a type of financial instrument that can be used to lock in the price of an asset at a future date. This can be a valuable tool for businesses and investors who want to protect themselves from price volatility. Futures contracts work by giving one party the obligation to buy an asset at a specified price on a specified date, and the other party the obligation to sell it.
The price is agreed upon when the contract is made, and it doesn't matter what the market price is on the delivery date. This means that if the market price goes up, the buyer of the futures contract will save money, and if the market price goes down, the seller of the a futures contract will make money.
As an example, imagine you are a wheat farmer. You know that you'll need to sell your wheat in a few months, but you're worried about the price going down.
You could buy a futures contract to lock in a price of Rs.100 per kg. This means that even if the market price of wheat goes down to Rs.80 per kg, you'll still be able to sell your wheat for Rs.100 per kg.
Futures contracts can also be used for speculation. If you think that the price of an asset is going to go up, you can buy a futures contract to lock in that price. If you're right, you'll make a profit when you sell the contract. But if you're wrong, you'll lose money.
Futures contracts are a complex financial instrument, and they're not right for everyone. But they can be a valuable tool for businesses and investors who want to manage risk or speculate on the future price of an asset.
What are Options?
An option contract gives the buyer the right, but not the obligation, to buy or sell an asset at a specified price on or before a specified date in the future. Options contracts require the buyer to pay a premium to the seller. If the buyer exercises the option, they will buy or sell the asset at the agreed-upon price, regardless of the current market price of the asset.
This makes options contracts a popular tool for speculation, as it allows traders to bet on the future price of an asset without having to commit to buying or selling it at the current market price.
For example, let's say that an investor believes that the price of oil is going to go up in the next year. The investor could buy an option to buy oil at a price of Rs.100 per barrel on January 1, 2024. If the price of oil goes up to Rs.120 per barrel on January 1, 2024, the investor can exercise the option and buy oil at Rs.100 per barrel, even though the market price is Rs.120 per barrel.
This would allow the investor to make a profit of Rs.20 per barrel. However, if the price of oil goes down to Rs.80 per barrel on January 1, 2024, the investor will not exercise the option and will lose the premium that they paid for it.
Key Differences between Futures and Options
Complexity: Both Futures and Options are called derivatives because they derive their value from an underlying market. Futures contracts create an obligation to buy and sell physical goods at a future date whereas Options Contract create the right but not an obligation to do the same.
Under Options contract you can buy or sell "Right to buy" or the "Call Option" and "Right to Sell" or the "Put Option" depending upon the market movement. This makes Options a more complex or advanced derivative to trade in.
Risk: The level of risk in Options is limited whereas Futures carry unlimited risk if the position is not closed. That's why Options were introduced where the buyer has the option to deny executing the Call Option if he feels that he will be disadvantaged. In this case, he will only lose the advance paid by him and would save him from further losses.
Premium: In an options contract, the buyer pays a premium to the seller for the right, but not the obligation, to buy or sell an asset at a specified price on or before a specified date. The buyer can choose to exercise the option or let it lapse.
If the buyer exercises the option, they will buy or sell the asset at the agreed-upon price, regardless of the current market price. The maximum loss that the buyer can suffer is limited to the premium paid. The seller, on the other hand, has unlimited loss potential.
In a futures contract, there is no premium payment. Instead, the buyer puts up a margin to initiate a position. The margin is a good faith deposit that is held by the exchange. If the market price moves against the buyer, they may be required to deposit additional margin. The maximum loss that the buyer can suffer is limited to the amount of margin that they have deposited.
Obligation: This difference in obligation is what gives options contracts their unique value. If you're not sure whether the price of an asset is going to go up or down, you can buy an options contract to give yourself the right to buy the asset at a later date.
If the price goes up, you can exercise your option and buy the asset at the lower price. But if the price goes down, you can simply let your option expire and you won't lose any money.
Futures contracts, on the other hand, are a more risky investment. If you buy a futures contract and the price of the asset goes down, you're obligated to buy the asset at a higher price. A significant loss could result from this.
Upfront Cost: In future's contract , there is a high upfront cost as compare to the option market. As both traded on exchange, so to avoid any default, exchange called for the margin requirement from both the buyer and seller. However, In forward market there is no upfront cost ,as it doesn't trade on exchange, it is an over-the-counter market derivative.
And if talk about the option market, the buyer has to pay only the token amount which is low as compared to the future's market.
This means that the buyer has more flexibility, as they can choose whether or not to exercise the option depending on the market conditions.
Types of Futures And Options
Types of Futures
Index Future: As the name suggests, index futures are futures contracts whose underlying value is based on a stock index.
Stock Future: You can purchase or sell stock futures at certain prices on specific dates based on a specific group of shares. Once the contracts have been purchased, traders must follow the conditions.
Currency & Commodity Future: Foreign exchange futures, also known as currency futures, let you buy and sell currencies at a specified price and time.
Interest Futures: An interest rate futures contract is one with an underlying asset offering interest. Both the buyer and seller agree to provide an interest-bearing asset at a specified price in the future.
Types of Options
Call option: In call options, traders can purchase the underlying financial security at an agreed price on a specified date.
Put option: Put options give you the opportunity to sell an underlying financial security at a predetermined price at a specific date.
Similarities Between Futures and Options
Futures and options are both financial derivatives, and they share several similarities:
- Derivative Instruments: Both futures and options are types of financial derivatives. They derive their value from an underlying asset, such as a commodity, stock, bond, index, or currency pair.
- Contractual Agreements: Futures and options involve contractual agreements between two parties, a buyer (long position) and a seller (short position), where the parties agree to buy or sell the underlying asset at a predetermined price on a specific date.
- Leverage: Both derivatives provide the opportunity for investors to control a larger position of the underlying asset with a relatively smaller amount of capital, which is known as leverage. As a result, potential gains as well as losses are amplified.
- Expiration Dates: Both futures and options contracts have expiration dates when the contractual obligations must be fulfilled or settled. Futures contracts typically have a specific delivery date, while options contracts have expiration dates by which the option must be exercised or allowed to expire.
Futures and options are both complex financial instruments that can be used to manage risk or speculate on the future price of an asset. Their characteristics, however, are different, and they serve different purposes. It is important to understand the difference between futures and options before using them.