Futures and options are derivative contracts traded on a stock exchange and derive their value from the underlying asset. Usually, investors use these contracts to make a profit or hedge against the risk related to the underlying asset. Also, these contracts help secure the asset’s price during market volatility. However, there are significant differences between futures and options.
Meaning of Futures
A futures contract is a derivative to buy or sell an underlying asset (stocks, commodities, ETFs, etc.) at a future date at a pre-decided price and quantity. Also, all these specifications are clearly mentioned in the contract. Furthermore, the buyer and seller have to fulfill the contract regardless of the current market price.
Futures contracts are very liquid as they trade on a stock exchange. Moreover, the stock exchange sets the margin requirement, the minimum amount a trader needs to deposit to trade. Therefore, the primary purpose of this instrument is to secure the price of the asset against market volatility.
Meaning of Options
An options contract is a derivative contract to buy or sell the underlying asset at a predetermined price on or before a specific date (expiry date). These contracts derive their value from the underlying security. The buyer of the option can buy or sell the underlying asset depending on the type of option. The two types of options are
- Call option – where the option holder has the right to purchase the underlying asset at a predetermined price
- Put option – where the option holder has the right to sell the underlying asset at a predetermined price.
The expiry date is the last Thursday of every month.
Futures vs Options : Key Differences
The following are the key differences between futures and options
|Risk||High risk||Limited risk|
|Degree of Profit/Loss||Unlimited profit or loss potential||Unlimited profit, limited loss potential|
|Buyer Obligation||Obligated to buy at a future date||No obligation to buy or execute the contract|
|Contract Execution||On a future date||Anytime before the expiry date|
|Price fall||May fall under zero||Cannot fall under zero|
|Volatility||Less price changes||Value declines overtime and fluctuates with underlying asset value|
|Advance payment||Not required||In the form of premiums|
|Preferred by||Speculators and arbitrageurs||Hedger|
Similarities Between Futures and Options
The following are the similarities between futures and options that keep the basics intact in these contracts –
- Both are derivatives contracts that trade on the stock exchange
- While drawing the contract, the key details about trade, price, quantity, and date are mentioned.
- Daily settlements happen for both futures and options.
- Both are standardized contracts where there is a margin account requirement.
- The underlying assets of these contracts are financial products like currencies, commodities, bonds, stocks, etc.
Frequently Asked Questions
The leverage of futures and options depends on underlying terms. For futures contracts, leverage depends on margin requirements and the investor. The minimum amount of margin determines the maximum leverage amount. For options contracts, the leverage depends on margin requirements and its terms. In other words, it completely depends on the premium paid.
Futures are riskier than options because any slight shift in the underlying asset price affects the trading more than trading in options. Also, it depends on the investor’s risk tolerance level.
Futures and options trading both have certain risks associated with them as traders have to make predictions and assumptions about the price movement of the underlying asset. However, the predictions may not always be correct. Therefore, thorough knowledge and understanding of the stock market and price fluctuations are required before trading futures and options.