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Difference Between Options and Futures

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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.

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.

 

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.

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.

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.

Futures vs options: which is better?

Futures and options have gained tremendous popularity with investors over the past few years. However, some differences between options and choices of futures are listed below to make a wise decision.

 

Options

Futures

ObligationIn an options contract, the holder is not obligated to buy/sell the asset.In contrast, the buyer is obligated to buy/sell the asset in a futures contract.
RiskSince traders are not obligated, they carry lower risks. But an option seller may carry higher risks.Due to the obligation, they carry higher risks.
PremiumIn an options contract, the buyer will have to pay a premium upfront.Conversely, the buyer does not have to pay a premium upfront in a futures contract.
Profit or lossThough the profit or loss could be unlimited, it reduces the risk of losing money.In a futures contract, there could be unlimited profits and losses.

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).

Difference between futures and options in terms of liquidity, price and value

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.

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Frequently Asked Questions

What are futures and options (F&O)? Explain with examples.

Answer Field

Futures and options are derivative contracts that derive their value from underlying assets like stocks or commodities. A future contract obligates the buyer to purchase an asset, while an option gives the buyer the choice to buy or sell the asset. For example, in an oil futures contract, the buyer agrees to purchase oil at a future date at a set price, regardless of the market price at that time. In an option, the buyer can decide whether or not to execute the contract.

Is F&O trading profitable?

Answer Field

F&O trading can be profitable if done with proper knowledge and risk management. While options and futures trading allow for substantial profits due to leverage, they also carry a high level of risk, which means traders can lose money just as quickly as they can make it.

Which is better, futures or options?

Answer Field

The choice between futures and options depends on an investor's goals and risk tolerance. Futures are best for those who want certainty and are willing to take on more risk, while options provide more flexibility and allow traders to limit potential losses while maintaining upside potential.

How long can you hold futures?

Answer Field

Futures contracts have specific expiration dates, meaning you can only hold them until the date mentioned in the contract. Most futures contracts last three months or less, although traders often close positions before expiration to avoid physical delivery or rolling the contract forward.

Which is safer: futures or options?

Answer Field

Generally, options are considered safer than futures because they provide the holder with the flexibility to decide whether or not to execute the contract. Futures obligate both parties, which increases the risk, especially in volatile markets. However, both involve risk and require a deep understanding of market dynamics.

How much money do you need to trade futures?

Answer Field

The amount required depends on the specific futures contract and the broker’s margin requirements. Typically, you need to deposit a percentage of the contract’s value, known as the initial margin. For example, if a futures contract is valued at $50,000, a broker may require a margin of $5,000 to $10,000.

How do I buy futures and options?

Answer Field

To buy futures and options, you need a brokerage account that allows derivatives trading. Once your account is funded and approved for trading, you can select the contracts you want to buy, whether for speculation or hedging.

Is futures option trading good?

Answer Field

Futures option trading can be beneficial for investors who want to hedge risks or take advantage of price movements without fully committing to a futures contract. It offers the potential for high returns, but it requires strong market knowledge and risk management.

What is the difference between futures and options trading?

Answer Field

The primary difference between options and futures lies in the obligation. Futures require the contract holder to complete the transaction on the expiration date, while options give the holder the right, but not the obligation, to execute the trade. This makes futures riskier but potentially more rewarding, whereas options offer more flexibility.

How risky is F&O trading?

Answer Field

F&O trading carries significant risks, especially due to the leverage involved. While the potential for large gains exists, there is also a high risk of loss, and inexperienced traders can quickly lose their entire investment. Proper risk management and understanding of market trends are crucial for reducing the risks involved in F&O trading.

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