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Futures v/s Options: Understanding the Differences

25 Feb 2022 0 COMMENT

Introduction:

Investing in derivatives can be highly profitable. Derivatives are fast gaining importance as money-making instruments and are also used to hedge risks. Before you decide on which derivative would be most suitable for you, you should understand how they differ from each other.

What are derivative contracts?

Derivative contracts are agreements that derive their value from the underlying asset that they represent. These underlying assets can be financial instruments like stocks, bonds, currencies, and commodities. While the value of a derivative is based on the underlying asset, the investor does not own this asset.

Futures

  • A Futures contract is an agreement to buy/sell a pre-determined quantity of an underlying asset on or before a given date in the future. The price is decided in the present.
  • In this agreement, the buyer and seller have an obligation to execute the trade on the said date.
  • Futures are standardised contracts that can be traded by investors in an exchange.

Options

  • An Options contract is an agreement to buy/sell an underlying asset at a pre-determined price. The contract has to be executed on or before the expiry date.
  • In an Options agreement, there is no binding or obligation on the buyer to execute the trade. The buyer has the option to refuse if the deal is no longer profitable.  
  • There are two types of options: Call and Put
  • A Call option is an agreement to buy an underlying asset at a pre-determined price before its expiry. A Put option, on the other hand, is an agreement to sell the concerned asset.

Why are Futures and Options used?

Futures and Options are important components of the financial arena. There are two key benefits to invest in these derivatives:

Hedging risks

Both these derivative contracts are largely used for hedging risks of volatility in exchange rates or commodity prices. They effectively safeguard businesses from price fluctuations.  

Earning through speculation

Options and Futures contracts are volatile in nature. This makes them an interesting alternative for speculative trading.

Differences between Futures and Options

 

Futures

Options

Obligation

A Futures contract is a standardized agreement between a buyer and a seller to trade a certain quantity of an asset at a particular date in the future at a pre-negotiated price. In a Futures contract, you are obligated to purchase the asset on the mentioned date in the future. 

An Options Contract enables you to purchase the said asset at a decided price. However, you are not obligated to proceed with the purchase. However, if you choose to buy, the seller is obliged to sell it as per the terms of the contract.

Risk Quotient

In this case, you have to proceed with the purchase on the stated future date even if the trade is unprofitable. For instance, if the price of the underlying asset drops below the price stated in the Futures contract, the purchase will still take place at the price mentioned in the contract as it is binding.

A Futures contract is riskier as it comes with potentially high profits or losses

In an Options Contract, you have an option to refuse the trade and opt-out of it if the price is not favourable to you. For instance, if the market price of the underlying asset drops below the price stated in an options contract, you can limit your losses by not proceeding with the trade.

An Options Contract is relatively safer as it can be profitable as well as shield you against losses to an extent.

Payment terms

There is no clause for advance payment in a Futures contract. You only have to pay the pre-decided price when you execute the trade.

In an Options contract, you have to pay a premium. This premium is the price paid for the opportunity to choose to not proceed with the contract if it is no longer profitable. If you decide to do so, you lose the premium paid in advance.

 

Trade execution date

Here, you have to execute the trade on the date stated in the contract.

Here, you can execute the trade on any date before the expiry of the contract. You can choose to buy at a time that is profitable to you.

Conclusion

Ultimately, your risk appetite and financial goals can guide you to the financial derivative instrument best suited for you. If you are a newbie in the derivatives market, be sure to read up and arm yourself with enough knowledge for a safe ride.

Disclaimer

ICICI Securities Ltd. ( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.