Contracts for futures require you to purchase or sell the commodity, but options for futures provide you the choice to buy or acquire the futures contract without having to.
However, let's first discuss listed futures and options before delving into their differences.
What are the Options?
Options are like financial tools tied to things like stocks, indexes, and ETFs. They let you buy or sell these things at a set price, but you don't have to if you don't want to, unlike futures. Every options contract has an end date, which will help you decide whether you want to use it. This set price is called the strike price. People usually trade options through online brokers or places where regular folks can buy stuff.
Example
Let's say you purchase a call option for Company X with an expiration date of one month and a strike price of Rs50. If, within that one month, the stock price of Company X rises above Rs 50, you can exercise the option and purchase the stock at Rs 50, even if it is currently trading at a higher price. This allows you to profit from the difference between the strike price and the market price.
What are the Futures?
Futures contracts are similar to contracts to purchase or sell financial assets or commodities at a predetermined price at a later time. They are exchanged on exchanges such as CME Group, although NSE future option stocks require brokerage accounts that have been approved. As with options contracts, there is a buyer and a seller in every contract. In contrast to options, however, futures require the seller to deliver the asset and the buyer to take possession of it. Hence, it requires a commitment from both sides.
Also Read: NSE or BSE
Example
Let's say you enter into a futures contract to buy 100 shares of Company Y at Rs 50 per share, with an expiration date after three months. If the price of Company Y rises above Rs 50 within that period, you can sell your contract and make a profit. However, if the price drops below Rs 50, you will still have to fulfil your obligation and buy the shares at the agreed-upon price.
What is the Difference Between Futures and Options?
Aspect | Futures | Options |
Definition | Contracts to buy or sell assets at a future date for a predetermined price. | Contracts that give the holder the right, but not the obligation, to buy or sell assets at a predetermined price by a specific date. |
Obligation | Obligates both the buyer and seller to fulfill the terms of the contract. | Grants the holder the right, but not the obligation, to buy or sell the asset. The seller (writer) has an obligation to fulfill the terms if the option is exercised. |
Flexibility | Less flexible because both parties are obligated to complete the transaction. | More flexible as the holder can choose whether to exercise the option or not. |
Risk | Higher risk is due to the obligation to buy or sell the asset, which can result in substantial losses. | Limited risk, as the holder can choose not to exercise the option if it is not profitable. The maximum loss is limited to the premium paid for the option. |
Profit Potential | Potentially unlimited profits if the market moves in favor of the position. | Limited profit potential as it depends on the price movement of the underlying asset. |
Premium | No premium is paid upfront. | Premium is paid upfront by the option buyer to the option seller. |
Market Requirements | Requires a margin account and approval for futures trading. | It can be traded with a regular brokerage account. |
Which One Should You Choose: Options and Futures?
Options offer minimal risk and strategic flexibility, while futures provide direct exposure at a higher risk. Depending on particular investing objectives and market conditions, a diversified approach might include both products. Because there is an obligation to buy or sell, futures carry a higher risk.
Because they are non-binding, options have less risk. Uncertain or range-bound markets may be more suited for options, whereas confident markets may favor futures. An investor's risk tolerance, preferred methods, and the state of the market all influence their decision between futures and options. Depending on particular investing objectives and market conditions, a diversified approach might include both products.
The Bottom Line
Options and futures are two important financial instruments that allow for speculation and hedging in the market. While they have some similarities, such as contracts that involve buying or selling an underlying asset at a predetermined price, their differences make them unique and suitable for different trading strategies. As a trader or investor, it's important to understand these differences and choose the right instrument depending on your risk tolerance and investment goals.
