Understanding Futures
Futures contracts are agreements between buyers and sellers to transact a specific quantity of an asset at a predetermined price, set for a future date. Unlike options, futures obligate the contract holder to complete the transaction when the contract reaches its expiration, regardless of market price fluctuations. These contracts are commonly used for commodities like oil or corn, or financial instruments such as stocks. Futures are often leveraged, meaning traders are only required to deposit a fraction of the contract's value, called margin. However, futures carry the risk of significant losses if the market moves unfavorably before the expiration. Understanding how futures work is crucial for those looking to manage risks or speculate on future asset prices.
The right to buy or sell a certain asset at a set price on a defined future date is known as a futures contract.
On the other hand, options grant the right to purchase or sell a certain financial instrument at a set price (known as the strike price) on a future specified date but without any obligation of doing so.
Suppose you think that the price of “XYZ company”, which is trading at Rs. 1000, will go up. So, you buy a futures contract at Rs. 1000.
If the share price appreciates, you will profit. However, if the price goes below Rs. 1000, say Rs. 900, you will make a loss.
In contrast, in a call option, you will pay a premium amount and if the price falls below your strike price, you can choose not to exercise the contract and you will only lose the premium amount. This is an inherent advantage of trading options.
Types of Futures
Commodity Futures: These contracts are based on physical assets like oil, metals, natural gas, and food grains. They help manage price risk, especially for farmers and primary crop producers, by locking in a sale price for their produce at a future date.
Currency Futures: These involve agreeing on an exchange rate for two currencies to be exchanged at a future date, helping to mitigate exchange rate risks in international trading.
Interest Rate Futures: Used to hedge against fluctuating interest rates, these contracts are tied to financial instruments like government bonds and bills.
Stock Futures: These include single stock futures and stock market index futures, allowing investors to hedge risks or speculate on the future price movements of individual stocks or market indices.
Financial Futures: Cover a broad range of financial instruments, including bonds, stock indices, and interest rates, used to hedge or speculate on financial markets.
Energy Futures: These contracts are based on energy commodities such as crude oil, natural gas, and electricity futures, helping to manage price risk in the energy sector.
Understanding Options
Options are financial contracts that provide the holder with the right, but not the obligation, to buy or sell an underlying asset, such as stocks or commodities, at a set price before or on a specific date. There are two types of options: call options, which allow the purchase of an asset, and put options, which allow the sale. The major advantage of options over futures is flexibility; holders can choose to let the contract expire without making a transaction. Options can be used to hedge risks or to speculate on the price movements of assets. Unlike futures, which are binding, options allow investors to limit potential losses while benefiting from favorable market shifts.
Types of options
In a futures contract, there is no type. However, in an options contract, there are two types of contracts.
Call options:
The right but not the obligation to buy a financial instrument on or before the expiry date at the pre-set strike price.Put options:
The right but not the obligation to sell an asset on or before the expiry date at a pre-set strike price.
Moreover, a call option is used when prices are anticipated to rise. When prices are expected to decrease, a put option is used.
Important options and futures terms
In an options contract, the key terms to understand are the strike price (i.e., the price at which the underlying financial instrument can be bought/sold), the premium (i.e., the option’s cost for the holder), and the expiration (i.e., the option’s settlement and expiration date).
In a futures contract, the basic terms are exercise price/futures price (i.e., the price of the asset that will be paid in the future), long (i.e., the trader who has purchased the futures contract) and short (i.e., the trader who is selling the futures contract).
Differentiation Between Options and Futures
Feature
| Options
| Futures
|
Definition
| Provides the right, but not the obligation, to buy/sell an asset at a predetermined price within a certain time frame.
| Obliges the holder to buy/sell an asset at a fixed price on a set date, regardless of market fluctuations.
|
Flexibility
| High; the holder can choose whether to exercise the option or not.
| Limited; the holder must execute the contract.
|
Risk
| Moderate; limited to the premium paid.
| High; exposure to losses can be unlimited.
|
Commitment
| Low; no obligation to buy or sell the underlying asset.
| High; mandatory execution at the set price.
|
Market Speculation
| Allows for speculation on price movements without mandatory purchase or sale.
| Involves a direct commitment to buy or sell.
|
Usage
| Primarily used for hedging, risk management, and speculation in trading futures and options (F&O trading).
| Commonly used for hedging, speculation, and managing price risk.
|
Options and futures are essential financial instruments in the world of trading, offering distinct advantages depending on the investor’s goals. Futures contracts require the holder to buy or sell the underlying asset at a predetermined price on a specific date, regardless of market conditions. Options, on the other hand, provide the contract holder the choice, but not the obligation, to buy or sell the asset. While futures involve more certainty and potential risk, options offer flexibility, making them a favored tool for hedging. Both, however, play a crucial role in mitigating risks and speculating on asset prices.
Options and futures are two varieties of derivative instruments. This implies that both instruments do not have any intrinsic value. Instead, they attain their value from underlying assets such as commodities, currencies, stocks, etc.
You speculate on potential price fluctuations when you trade in stocks, futures, or options. If the prices do not move in your preferred direction you may lose a significant amount invested, as it involves leverage and taking high positions.
That is why it is essential to understand the futures and options differences.
Futures vs options: which is better?
Futures and options are two of the most popular derivatives in financial markets, each serving distinct purposes for traders and investors. Both allow participants to speculate on or hedge against future price movements of assets such as stocks, commodities, or currencies. However, the choice between futures and options depends on factors like risk appetite, investment strategy, and market outlook.
- Futures contracts: Futures are binding agreements where both parties must buy or sell the underlying asset at a predetermined price on a specified date. They offer high liquidity and transparency but expose traders to unlimited risk if the market moves unfavourably.
- Options contracts: Options give the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a set price before expiry. They involve paying a premium upfront but limit the potential loss to the premium paid, offering better risk control.
- Risk profile: Futures involve higher risk since gains and losses are unlimited and daily margin calls are mandatory. Options, in contrast, cap the loss to the premium, making them safer for cautious investors seeking exposure to market movements without risking their entire capital.
- Cost: Futures typically involve lower upfront costs because you only need to deposit margin money, whereas options require payment of a premium, which might be significant depending on volatility and time to expiry.
- Suitability: Futures suit traders who are confident in a directional move and can handle daily mark-to-market settlements. Options are better for investors looking to limit their downside or create complex strategies like spreads, straddles, or covered calls for hedging or income generation.
- Flexibility: Options provide more strategic flexibility as you can construct trades with varying degrees of risk and reward profiles. Futures are straightforward but lack this strategic diversity.
Where are options and futures traded?
Both options and futures contracts are standardized contracts traded on markets like the BSE and NSE. This is usually facilitated by a broker, or a trading app . A margin account with a broker or a trading app is necessary to trade options or futures.
Investors use futures and options strategies to hedge their portfolios or make profits based on market conditions.
Difference between futures and options in terms of liquidity, price and value
Term
| Description
|
Strike Price
| The price at which the underlying financial instrument can be bought or sold in an options contract. (Futures and Options, F&O trading)
|
Premium
| The cost of the option for the holder in an options contract. (Futures and Options, trading futures and options)
|
Expiration
| The settlement and expiration date of the option in an options contract. (Futures and Options, futures trading strategies)
|
Exercise Price/Futures Price
| The price at which the asset will be bought or sold in the future in a futures contract. (Futures and Options, trading futures and options)
|
Long
| The trader who has purchased the futures contract. (Futures and Options, F&O trading)
|
Short
| The trader who is selling the futures contract. (Futures and Options, F&O trading)
|
Compared to options contracts, futures contracts are more liquid. Regarding price, futures contracts often cost less than options because they are less volatile, and you don’t have to pay an upfront premium as well.
Futures and options contracts lose value with every day that passes. As options approach their expiration date, this phenomenon known as time decay tends to intensify.
What similarities exist between options and futures?
Option and future contracts are exchange-traded derivative contracts trading on stock exchanges like the NSE and BSE and are subject to daily settlement. Moreover, traders need a margin account with the broker for options and futures.
Finally, both contracts have the same underlying financial instruments, such as currency, stock, commodities, bonds, etc.
Final Takeaway
Understanding the nuances between options and futures is essential for any trader or investor. Options provide flexibility by giving the holder the right, but not the obligation, to buy or sell an asset at a predetermined price before its expiration. This structure allows investors to manage risk more effectively, limiting their maximum loss to the premium paid.
Futures contracts, on the other hand, are binding agreements that obligate both parties to buy or sell an asset at a future date. These contracts require a larger financial commitment and carry higher risk, especially because they involve daily margin calls and the potential for substantial losses if the market moves against the trader’s position. While both options and futures serve as tools for speculation and risk management, they cater to different investment strategies and risk tolerances. The choice between options and futures depends on an investor’s objectives, risk appetite, and market outlook.
