Table of contents
- What are the salient features of futures?
- What are the salient features of options?
- How to understand futures better?
- How can you form a clear understanding of options?
- Is trading in futures and options always profitable?
- Futures vs options
- Bottom line
Futures and options are both important hedging tools in the financial markets. The key difference, however, is that options give you the choice to fulfil the contract, but futures obligate you to do so.
What are the salient features of futures?
While discussing future and options trading, you need to understand their unique characters. For example, in the case of the futures:
- They experience limited change in price.
- Sometimes, the price can fall as low as $0.
- They define the future market price of an underlying in the present.
What are the salient features of options?
In case of options:
- As a contract holder, you have no obligation to purchase an underlying asset.
- The contract itself predetermines the price of investment in the future.
- The intrinsic value of an option can never go below $0.
- In stock, the option’s value would slowly lessen over time. It changes quite visibly with the changes in the underlying asset’s value.
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How to understand futures better?
A trader can enter a futures contract with a small investment called the initial margin. Brokers use the margin account to debit or credit the proceeds every day, based on price fluctuations in the futures contract.
The balance is settled on or before the expiry of futures contracts, where both traders exchange securities and cash.
How can you form a clear understanding of options?
There is no obligation to sell or buy under options contracts. Option contracts are of two types:
- Call: The option holder has the choice to buy the underlying asset.
- Puts: The option holder has the choice to sell the underlying asset.
An options trader exercises the call option if the market price to buy the security is higher than the strike price in the options contract. Else, the trader cancels the contract. Similarly, a put option is exercised if the market price to sell the security is lower than the options strike price.
Is trading in futures and options always profitable?
While discussing future and options trading, you should know that futures can yield both unlimited profits, as well as unlimited losses.
Even options can bring back and forth unfathomable loss and profit. However, it acts as a shield from incurring severe loss.
Futures vs options
Both futures and options are derivative contracts whose prices depend on the underlying asset. They are both strategic tools used for hedging and speculation.
- The dates of the contract affect trading. While an option allows you to trade anytime before the option expires, futures contracts do not give you this flexibility.
- In most cases, if you sell a futures contract before its expiry date, it would prevent you from having delivery of anything that you trade with. Again, with options, there is no need to exercise. Even if there is insufficient investment or business to exercise, it can expire with minimal expenses. Sometimes, only the amount you paid for the premium becomes its only cost.
Which one is relatively inexpensive?
Futures are indeed enormous in business volume. However, they need minimal margin or upfront payment. On the other hand, purchasing options contracts would require you to pay your writer some premium. This amount would depend on your traders’ judgement of the upcoming market, as well as the spot price of the underlying asset.
You can say that, typically, futures are less costly than options. But then again, the margin requirement of futures can be high. It can range between 3-12% of the overall trade volume.
Which one is safer?
Both these trading options have their share of risks. You have to exercise options contracts on time. Otherwise, it can lose its value fast. This can pave the way to a total loss. However, as an individual investor, you might get exposed to bigger threats while trading in futures.
Hopefully, you may now have clarity regarding “what are futures and options?” Now that you can analyse the main differences between these two forms of trading, you can make your decisions more confidently than before.
As an investor, it always helps to gather as much information as possible before taking a plunge.
You are a commodity trader in oil. The price is currently ₹600 per barrel, and you expect it to increase to ₹700. You need 200 barrels next month. So, you enter a futures contract with a bearish trader to buy oil at ₹600 per barrel, next month.
Like all other stock market transactions, futures and options traders must open demat and trading accounts with brokerage platforms registered with NSE and BSE. Traders can then look for futures and options available with the broker and place an order for the same, after thorough research.
Futures contracts can be risky if the market price moves against the trader’s speculation. To cover for the loss, traders are required to deposit a margin amount with brokers while opening a futures position, which will be adjusted according to price fluctuations in the market.
While the options holder has the privilege to cancel the contract, the options seller is obligated to fulfil the contract, even if it is not profitable. So, the buyer of options pays a premium to the options seller, to compensate for the loss of fulfilling the options contract.