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What is the difference between Futures and Options?

What is the difference between Futures and Options?

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Options and futures derivatives have been recognized to distinguish between investors seeking to benefit from the price change in commodities or similar investments and those simply hedging their bets. The main difference between options and futures is that the contract holder must exercise underlying assets, such as commodities or stocks, at a future date. On the other hand, an option allows the contract holder to decide whether or not he will execute the contract in the derivative market.

This difference impacts how options and futures are traded and priced and how traders can profit from them.

Let's focus on the future first. Think that the share price of XYZ company, which is at 100 Indian rupees right now, would rise. You're trying to make some money by taking advantage of this opportunity. You'll buy 1000 futures contracts for XYZ company at a strike price of Rs 100. Whenever the cost of XYZ company rises to Rs 150, you can exercise your right and sell your futures at Rs 100 each and gain Rs 50,000.

Remember that options give you a right, not an obligation, to buy or sell. If you had purchased the same amount of options at ABC company, you could have exercised your right to sell options at Rs. 150 and made a profit of 50,000, just like a futures contract. The option of not exercising the right will save you from a loss of INR 50,000 if the stock price falls below Rs. 50.

This should make it easier to see the difference between futures and options.

Understanding Options Trading

An options contract is a derivative contract to purchase and sell an underlying asset at a price fixed on or before its expiration date. The value of these contracts is determined based on security. The buyer may purchase or sell the underlying asset depending on the option type. The two options are as follows:

  1. Calls:

    An option to purchase an underlying asset at a specified rate on a particular date is offered to the contract holder. Consequently, they are not required to acquire such assets.

  2. 2. Puts:

    This allows the contract holder to sell the underlying asset at a determined rate by a specific date. The holder is not obliged to buy these assets once more.

  3. Investing in a call option is a bet that the respective underlying assets will acknowledge their value before the expiration of the contract. By contrast, a put option can be the bet that prices will decrease or remain unchanged. For successful investments, this requires a high level of expertise.

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Table of Content

  1. Understanding Options Trading
  2. Understanding Futures Trading
  3. Options vs Futures - Which is better?
  4. Factors making a difference between Futures and Options
  5. Difference between Futures and Options based on Liquidity
  6. Difference between Futures and Options based on Value
  7. Difference between Futures and Options based on Capital

Understanding Futures Trading

Futures are nothing more than futures contracts. A futures contract is when a contract holder buys underlying assets on a predetermined date despite the asset's market price. As a result, once the contract is purchased, they decide how much to pay. Any physical commodity, such as oil, corn, or other financial assets, can be an underlying asset.

The standardised amount shall be used in futures contracts for each main asset. You will not be required to place a total value on the contract when purchasing futures contracts. By contrast, you hold a significantly small proportion of the funds needed to finance your investment, referred to as first margin payments. Moreover, there will be variations in the contract value.

In addition, your broker may require you to deposit money if you experience a significant loss. 

Most commodity traders tend to liquidate their positions before expiration. You may obtain sufficient funds to cover the margin loan when you sell a futures contract, and that may give you some profit.

Options vs Futures - Which is better?

After understanding the difference between futures and options, both derivatives have gained traction due to their advantages—lower risk, leverage, and liquidity. Let’s see which is better for you.

Futures

Options

Gained popularity due to lower risk, leverage, and high liquidity.Became popular among investors for similar advantages.
A derivative instrument tied to an underlying asset's value.Classified as derivatives dependent on underlying asset value.
Applicable across various assets like stocks, indices, currencies, and commodities (e.g., gold, silver, wheat, etc.).Derivatives are available for multiple financial instruments and commodities.
Utilized for both hedging against volatility and speculative purposes.Used for hedging risks caused by market volatility and for speculating on price movements.
Beneficial for producers, traders, and investors facing potential losses due to market fluctuations.Facilitates potential gains for speculators accurately predicting price movements.

Factors making a difference between Futures and Options

Factors that make a significant difference between futures and options are listed below;

  1. Obligation

    A futures contract is a contractual agreement for an asset to be bought and sold at some price in the future. In this case, an asset is to be purchased by the buyer at a specified future date.

    The buyer will be entitled to purchase the asset at a fixed price under an option contract. However, the buyer has no obligation to go ahead with the purchase. The seller must sell it if the purchaser chooses to purchase an asset.

  2. 2. Payment

    When a futures contract is signed, there will be no upfront costs. However, the buyer will ultimately make the final payment of the agreed price for the asset. A premium has to be paid by the purchaser of an option contract. The option buyer is granted the right not to buy an asset on another date if it becomes less desirable due to this premium payment. The premium paid is the amount lost if the option holder chooses not to buy the asset. You may be required to pay a specific fee in either of these cases.

  3. Risk

    A futures contract holder must buy at a future date, even if that security moves against them. In this case, the asset's market value is below the price specified in the contract. The buyer will still need to buy it at a price agreed earlier and incur losses.

    Here is an advantage to the buyer of a contract for options. The buyer may exclude himself from buying it if the asset value does not match the fixed price to be paid. That limits the loss to be incurred by the buyer. A futures contract could be an available source of profit or loss. In the meantime, an option contract could produce unlimited profits, but it would limit potential losses.

  4. 4. Contract execution

    The date on which the contract was concluded shall be considered in the execution of a futures contract. The purchase of the underlying asset is made by the buyer at that date. In addition, a buyer may execute the option contract by the expiration date. It means that when you feel the right conditions are in place, you can buy an asset.

The table below clearly indicates the difference between futures and options in detail.

 Options Futures
  1.  RiskThey are subjected to limited riskHigher risks are involved.
  2. Advance PaymentThe buyer has to pay an advance premium payment. The advance gives the option buyer a chance not to buy any asset if the future date is unattractive.No advance payment is involved in the future. The buyer just needs to pay the price of the asset.
  3. ExecutionOptions can be executed anytime before the expiration date.Futures contracts are executed on a specified agreed date.
  4. Profit or lossIt can either give you a profit or a loss. The outcome is not specified.Futures almost always bear profits for buyers.
  5. ObligationThe buyers are not obligated to meet a specific date to buy the contract.The buyer is obligated to buy the contract by a predetermined date to buy a contract.

Difference between Futures and Options based on Liquidity

The most basic type of commodities derivative is a futures contract. They are the closest thing you can get without really trading a commodity to trading the real one.

Comparatively speaking, these contracts are more liquid than option contracts. Futures contracts are, therefore, more suited for day trading. 

Difference between Futures and Options based on Value

Because options move in combination with futures contracts, futures contracts move quicker than option contracts.

For in-the-money options, this may be 50%, while for severely out-of-the-money options, it might only be 10%. You don't have to be concerned about the option value gradually declining over time.

Difference between Futures and Options based on Capital

The capital value of futures options is regarded as high risk. Put another way, alternatives are becoming less and less valuable every day. Time decay is the term for this, and it becomes worse as options go closer to expiry.

Consequently, it is possible to characterize futures and options as exchange-traded derivative contracts that are transacted on stock exchanges like the National Stock Exchange or the Bombay Stock Exchange.

Making the most effective use of these instruments is crucial for trading futures vs options differences. Their coverage includes financial instruments such as equities, bonds, currencies, commodities, and more.

Conclusion   
As discussed above, these derivative contracts are customised according to counterparties' requirements. Options contracts may decrease losses as opposed to futures contracts, guaranteeing an obligation that will be fulfilled at a particular time. To improve the investor's ability to make better informed and well-reasoned choices, an analysis of key differences between futures and options and how they are bought and sold plays a vital role. It was all you could have known about options and futures.   
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Frequently Asked Questions

Many factors can be attributed to your tolerance for risk, but in general, futures are more risky from the perspective of options. A futures contract is an arrangement between buyers and sellers of an asset to be traded at a determined price in the coming month, meaning both parties are tied into that transaction.

Options typically offer more leverage compared to futures. With options, traders can control a larger position with a smaller investment, owing to the premium paid for the option contract.

A futures contract allows the holder of a particular asset to buy or sell that asset at a specified price on a future date. The option confers the right to purchase or sell an asset at a fixed price on that date but does not make it obligatory.

Assets must be bought or sold in the futures contract at a fixed price and time. However, options give buyers the right but not the obligation to engage in trade. There is enormous potential for them to make a significant profit.

Your level of risk tolerance may be a factor when comparing futures and options, but it is a given that futures are riskier than options. When trading options, even small changes in the underlying asset's price significantly impact trading.


 

It is more risky to sell options than to buy options because of the unlimited risks involved.