Futures and options are derivative contracts in financial markets, available on exchanges such as the NSE and BSE. While both serve as tools for traders and investors, understanding their differences is crucial to using them effectively.
This guide explains the difference between futures and options, providing insights into their features and how they differ.
What are Futures and Options?
What are Futures and Options? Futures contracts are agreements where two parties commit to trading (buying or selling) an asset at a predetermined price at a future date. They can involve a range of assets, including commodities, currencies, and securities.
While, Options contracts give buyers the right but not the compulsion to buy or sell an underlying asset at a specified strike price before an expiry date. Buyers pay a premium for this right without any commitment to exercise the option if unfavourable.
There are two main types of options:
- Call Options: It allow the holder the right to purchase the underlying asset at a specified strike price. Traders buy call options because they expect the asset’s price to rise.
- Put Options: Allows the holders to sell the asset at a predetermined strike price. Traders generally purchase put options when they expect the asset’s price to fall.
Key Features of Futures Contracts
- Standardised terms: Includes asset quality, quantity, and delivery date.
- Trading: Conducted on exchanges with transparent pricing.
- Margin Requirements: Requires posting high margin for leveraged exposure.
- Daily Settlement: Profits and losses are marked on the market daily.
- Uses: Commonly used for hedging or speculation based on anticipated future price movements.
Key Features of Options Contracts:
- Right to Trade: Provides the right, not the obligation, to buy or sell the asset.
- Expiry Date: Contracts have a predefined expiry date.
- Premium: The strike price determines the options premium, underlying asset volatility, and time remaining to expiration.
- Uses: Suitable for directional trading, hedging, and various income strategies.
Key Difference Between Futures and Options
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Understanding the difference between futures and options involves looking at several factors:
1. Obligation vs Right
Futures contracts create an obligation to trade the underlying asset, while options provide the right but not the obligation.
2. Risk Profile
Futures have symmetrical risks for both buyers and sellers. The risk profile in options trading is asymmetric – option buyers have limited downside risk capped at the premium paid. In contrast, option sellers take on unlimited risk if the market moves against them.
3. Leverage
Another difference between futures and options is that Futures provide higher leverage but require posting high margins as collateral. Options expose traders to the price movements of the full value of the underlying asset while capping the capital requirement to the amount paid as a premium.
4. Profit Potential
Both futures and options offer uncapped profit potential. However, options profits depend on the amount in the money at expiry unlike futures.
5. Trading Flexibility
Options allow a wider range of trading strategies to profit from range-bound or volatile markets. Futures have limited strategy flexibility.
Go through the table to understand the difference between futures and options better.
| Comparison Basis | Futures | Options |
|---|---|---|
| Underlying Obligation | Binding obligation to buy or sell | Right to buy or sell, not an obligation |
| Risk Profile | High risk, symmetric for both buyers and sellers | Option buyers with limited risk of premium paid while sellers with potentially unlimited risks |
| Margin Requirements | High margin required for full contract value | A lower margin needed compared to futures |
| Pricing Factors | Converges to the underlying asset’s spot price at expiration | Based on strike price, underlying volatility, and time to expiry |
| Loss Potential | Potentially unlimited if prices move unfavourably | Risk limited to the premium paid |
| Profit Potential | Uncapped profits if price moves favourably | Profits depend on how much the asset is in the money at expiry |
| Trading Strategies | Limited strategies, mainly speculative or hedging | A broader range of strategies, including income and volatility plays |
| Settlement | Settled by delivery or cash at expiry | Settled according to the exercise decision |
| Common Purpose | Hedging against future price risk | Hedging, directional trading, and exploiting volatility |
Difference Between Futures and Options With Examples
To illustrate futures and options differences, consider these examples:
Example of Futures
Suppose an investor enters into a futures contract to buy 100 units of an index at ₹10,000 at the end of 3 months. Regardless of where the actual index level is at that time, they are obligated to buy 100 units of the index at ₹10,000. The seller must fulfil a contract for 100 units at ₹10,000.
Example of Options
An investor buys a call option on ABC stock with a ₹50 strike price expiring in 6 months for a ₹2 premium. This provides the right but not the obligation to buy ABC at ₹50 on expiry.
If ABC exceeds ₹50, the buyer can exercise the option and realise a profit. The maximum loss is ₹2 premium. The seller must sell ABC at ₹50, regardless of the current market price if the option is exercised.
Options Trading vs Future Trading: Which is Better?
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When comparing option trading vs future trading, consider the following:
Futures are better if:
- You want to hedge against potential adverse price moves in commodities or currencies you deal in.
- You are firmly convinced about future price direction and want leveraged exposure to profit from it.
- You want fixed upfront pricing without ongoing premium costs.
Options are better if:
- You want to profit from a directional view but with defined and limited risk.
- You want to earn regular income by selling options premium.
- You want to exploit volatility without directional bias using strategies.
- You want to hedge your portfolio at a low cost compared to futures.
Futures are best suited for hedging or speculating using leverage. Options offer flexibility for directional trades, hedging and income generation. Evaluate your trading objectives and risk appetite before choosing between futures and options.
Which Trading is Best for Beginners?
Options might be a better starting point than futures due to their flexibility and limited risk. However, both require understanding their mechanisms and carefully considering your trading goals.
F&O trading, which involves futures and options, provides tools for diverse strategies but also requires a solid grasp of futures and options and their respective risks and benefits.
The Bottom Line
By exploring the option trading meaning, how to do options trading, and the difference between future and option contract, you can make more informed decisions and better align your trading approach with your financial objectives.
FAQs
What is the difference between futures and options?
Futures represent an obligation to buy/sell the asset at a pre-set price on expiry. Options represent the right without obligation to buy/sell assets at the pre-set price on or before expiry.
Are futures and options leveraged products?
Yes, futures and options enable traders to take much larger positions with smaller margin capital due to embedded leverage, controlling bigger asset values.
Which has higher risk – futures or options?
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Futures have a higher risk as they come with the obligation to settle as per the agreement. Options buyers have the right to execute the trade without a mandatory requirement on expiry.
Which has a defined, fixed expiry date?
Both futures and option contracts have defined, fixed expiry dates after which settlement obligations arise in case open positions exist.
Can futures and options be settled before expiry?
Yes, futures and options can be settled before the official expiry date by squaring off open positions earlier for risk management.
Which needs higher margin requirements?
Futures generally require higher minimum margin cover given the compulsory settlement contracts carry before trading.
