Difference Between Futures and Options

More on Derivatives

Difference between Futures and Options comes in multiple ways and it really comes down to the preference of the trader and his/her risk appetite. In this detailed review, we will have a close look at all such differences and furthermore, we will take the help of an infographic to go along with a video review.

All this is to make sure, you never have to look for the difference between futures and options anywhere else again!

But first, the basics.

Derivatives are the financial contracts that derive their value from the underlying assets. The underlying assets, in this case, can be stocks, commodities, indices, currencies, rate of interest or exchange rates. 

They are an efficient way to trade in the market in order to make profits and limit losses.

Depending on the conditions of the contract, derivatives can be of the two main types- Futures and Options. Both types of derivatives have their own ways to work with, pros and cons etc.

And in this detailed review, we will be focussing on the difference between futures and options in your regular stock market trading.

Difference Between Futures and Options

Both futures and options are derivatives wherein their value depends on the value of the underlying asset, and the contract allows the trader to buy or sell an asset at a future date at a future price. However, futures and options differ on various parameters.

Both futures and options are the means to make profits and to reduce losses by making speculation about the price movements in the market. Keeping the basic premise same, but the conditions and other parameters differ.

In essence, a futures contract is an obligation to the buyer to buy an asset and to the seller to sell the asset, at the future price at a specified future date whereas an options contract gives the buyer a right, and not an obligation, to buy the asset and the seller has an obligation to sell the asset at a predetermined price at any time during the life of the contract.

Hence, the futures contract is binding to both buyer and seller, whereas the options contract is binding on the seller and the buyer may or may not choose to exercise his option. Options offer versatility and can be used in various strategies whereas futures are simple and easy to understand.

Here is a quick infographic explaining you the difference between futures and options:

In terms of fee, a futures contract can be entered without paying an upfront fee but an options contract requires the payment of an upfront fee as premium, which can be considered as the fee for the right to exercise or not exercise the contract.

Although the margin payment required for futures is higher than options because the futures market is considered riskier than options as both the parties are exposed to risks of high losses in the futures contract.

The futures contract has unlimited potential of profit and loss, whereas in an options contract the profit potential is unlimited but the risk is only limited to the premium paid as the buyer of an option may choose to not exercise it in case the market goes against his expectations.

Futures and options also differ in how are the profits are made. In an options contract, profits can be made by exercising the option when it is in the money, or by taking the opposite position in the market or by letting the contract expire and collect profit from the difference between the current price and the strike price.

However, in the case of a futures contract, profits are marked to the market or can be realised by taking opposite positions.

Then, there is no time factor in the case of the futures contract since the agreement is definitely going to be exercised on the expiration date. This is not mandatory when it comes to options trading and thus, the time factor has a crucial role to play in this kind of trades.

Thus, both futures and options have inbuilt characteristics that make them stand out in different situations; and both have their advantages and disadvantages.

Both differ on various parameters but hold the same basic essence. In order to be able to trade in futures and options, a trader needs to be very knowledgeable and cautious. Due diligence is required to trade in all forms of derivatives.

No trading method is fool-proof and none promises unlimited guaranteed profits and absence of losses. The trader has to conduct his own research and make decisions depending upon his own personal trading style, risk appetite, capital availability, current requirements and market situation.

Difference between futures and options – Summary

Before we wrap up this detailed review on the difference between futures and options, let’s go through a quick summary:

  • Futures trading gives the trader a right and an OBLIGATION to fulfil the contract while in options trading, there is no such obligation in place.
  • Futures trading has much higher risk involved as compared to options trading
  • Futures trading does not require any upfront fees while you need to pay a nominal premium while entering into an options contract.
  • Profits and loss have no limitation when it comes to futures trading while there is a cap on the loss you may go through in an options contract.
  • Time plays an important role in options contracts while in case of futures trading, the agreement is going to be definitely exercised on the expiry date and thus, it has little significance there.

In the end, it needs to be understood that there is no one kind of trading between futures and options that is better than the other. It really depends on the trader’s preference, risk appetite, investment objectives, time horizon and other related factors to pick the one that suits them at that point in time.

While options trades can help you in reducing the loss, futures contract assists you with a definite potential gain (as long as you are trading objectively).

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More on Share Market Education:

If you are looking to learn more about the share market, here are a few reference links for you:

 

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