Options vs. Futures: What’s the Difference?

By 5 Circles Pvt Ltd | Updated August 03, 2024
Reviewed by Vaishnavi Dixit

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In the world of financial derivatives, options and futures stand out as two popular instruments that investors use to speculate on market price movements or hedge against potential risks. Although they share some similarities, options and futures have distinct characteristics, rules, and risks. Understanding these differences is crucial for investors to make informed decisions and optimize their trading strategies.

What are Options?

Options are financial derivatives based on the value of an underlying asset, such as a stock, index, or commodity. An options contract gives the investor the right, but not the obligation, to buy or sell the underlying asset at a predetermined price (strike price) within a specific time frame. Options come in two primary types: call options and put options.

• Call Options: Provide the right to buy the underlying asset at the strike price before the contract expires.
• Put Options: Provide the right to sell the underlying asset at the strike price before the contract expires.

Example of a Call Option

Consider an investor who buys a call option to purchase stock XYZ at a ₹4,000 strike price within the next three months. If the stock’s price rises to ₹5,000, the investor can exercise the option to buy the stock at ₹4,000, then sell it at ₹5,000, earning a ₹1,000 profit per share. Alternatively, the investor can sell the call option itself, which would now be worth ₹1,000 per share due to the price increase.

Example of a Put Option

An investor holds a put option to sell stock XYZ at ₹8,000. If the stock's price drops to ₹6,000 before the option expires, the investor can exercise the option to sell the stock at ₹8,000, realizing a ₹2,000 profit per share minus the premium paid for the option. If the stock's price remains above ₹8,000, the option expires worthless, and the investor loses the premium paid upfront.

What are Futures?

Futures are standardized contracts obligating the buyer to purchase, and the seller to sell, an asset at a predetermined price on a specific future date. Unlike options, futures contracts require both parties to fulfill the contract terms unless the position is closed before the settlement date. Futures are commonly used for commodities like oil, corn, or financial instruments such as indices and currencies.

Example of a Futures Contract

Consider a farmer and a trader agreeing on a corn futures contract at ₹600 per quintal. If the market price of corn rises to ₹800, the trader profits ₹200 per quintal, while the farmer misses out on the higher market price. Conversely, if the price drops to ₹400, the farmer benefits by having secured a higher selling price, while the trader incurs a loss.

Key Differences Between Options and Futures

1. Obligations and Rights

• Options: Offer the right, but not the obligation, to buy or sell the underlying asset.
• Futures: Require both parties to fulfill the contract's terms at the specified future date.

2. Risk Exposure

• Options: The risk to the buyer is limited to the premium paid. However, the seller (writer) of an option faces unlimited risk if the market moves against them.
• Futures: Both buyers and sellers face significant risk due to the obligation to transact at the contract price, regardless of market movements.

3. Margin Requirements

• Options: Buyers pay the premium upfront, while sellers may need to maintain margin accounts.
• Futures: Traders must post initial margin and may need to adjust it as the market price fluctuates, with daily mark-to-market adjustments.

4. Market Participation

• Options: Attract both retail and institutional investors due to their flexibility and limited risk for buyers.
• Futures: Primarily serve institutional investors and commodity producers or consumers hedging against price volatility.

Examples of Options and Futures

Options on Futures

Options can be written on futures contracts. For example, an investor might purchase a call option on a gold futures contract with a strike price of ₹1,50,000, paying a premium of ₹2,000 per contract. If the price of gold rises above ₹1,50,000, the investor can exercise the option to buy the futures contract or let the option expire if the price remains below the strike price.

Futures on Commodities

A trader might buy a futures contract for 1,000 barrels of oil at ₹7,000 per barrel. If the price of oil rises, the trader profits from the price increase. However, if the price drops, the trader incurs a loss, highlighting the inherent risk in futures trading.

Conclusion

Both options and futures offer unique opportunities and risks for investors. Options provide flexibility with limited risk for buyers, making them attractive for speculation and hedging. Futures offer a straightforward, albeit riskier, approach to locking in prices for commodities and financial instruments. Understanding the key differences between these derivatives is essential for effective trading and risk management.

Disclaimer

Trading futures, options on futures, and retail off-exchange foreign currency transactions involves substantial risk of loss and is not suitable for all investors. Past performance is not indicative of future results. Consider your financial situation, investment objectives, and risk tolerance before trading. You may lose all or more of your initial investment. Opinions, market data, and recommendations are subject to change at any time.

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