Explain the Differences between Futures and Options

In this article, we will discuss

• Concept of Futures
• Concept of Options
• Futures vs Options: A Comparison
• Final Words
• Frequently Asked Questions

Trading in derivatives is getting popular among Indian investors. Of the different types of derivatives, futures and options are traded in the stock exchanges, while there are other types of derivatives such as forwards and swaps which are traded over the counter. Futures and contracts are derivative instruments which derive their value from an underlying asset which can be a stock, indices or a commodity like gold.

Here in this article, we will deep dive into the concept of futures and options along with an in-depth comparison between the two.

Concept of Futures

Futures contracts are a type of derivatives which bind two parties to trade on an underlying asset at a specific price on a predetermined future date. They are framed following standardised procedures which means that they have a set of pre-defined terms and conditions covering the delivery date, quality specification and asset quality.

Unlike options, a futures contract imposes an obligation on both the buyer and seller to buy or sell an underlying asset and fulfil the terms of the contract. It provides a surety that a transaction will take place as per agreed-upon terms and price irrespective of market fluctuations.

Futures are mostly used in various types of commodities like agricultural products, oil and precious metals like gold. Apart from commodities, stock indices and currencies are also used as an underlying asset.

It allows investors and traders to hedge against price fluctuations and speculate or forecast future price movements.

Concept of Options

Options are contracts between a buyer and seller which give the buyer the right but not an obligation to buy or sell an underlying asset on or before the date of expiry and at a predetermined price. Unlike futures, option buyers do not have an obligation to execute transactions. However, options sellers have an obligation to exercise the contract.

Holding an option contract allows buyers the right to buy or sell underlying assets if the current market price of the asset is favourable for them. Otherwise, buyers simply can choose not to execute the contract. Therefore in such a scenario, the loss amount will be up to the extent of the premium paid by a buyer.

Options are of mainly two types: call option and put option. A call option allows the contract buyer to buy an underlying asset at a predetermined price and date. A put option allows a buyer to sell an underlying asset at a predetermined price and date.

Futures vs Options: A Comparison

Here is a comparison between futures and option contracts based on certain parameters.

Final Words

Now you must have some clarity on the futures and options contracts and differences between these derivatives. Hopefully, by now you will be able to make a decision based on your investment objectives and risk tolerance. Please note that futures come with a higher risk associated with it as you will have an obligation to exercise the contract irrespective of the market condition which is not the case with options.

Frequently Asked Questions

1. Which are more expensive futures or options?

Ans. Usually, futures are comparatively cheaper than options as these are less volatile in nature.

2. Are futures more risky than options?

Ans. Yes, futures are considered more risky, as futures are directly linked with the asset price and volatility while options are more responsive to the change in price of the underlying asset in a different way and allow a greater flexibility to limit your losses.

3. Which provides higher leverage: futures or options?

Ans. A future contract offers higher leverage as compared to an option contract. Moreover, futures come with higher liquidity contributing to the low spreads.

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