Futures vs. options

FUTURES VS OPTIONS

Having explained so far, we are hopeful that you’ll be able to chart out the difference between a futures and options.

Both are traded in stock exchanges and both are derivative instruments. Option and futures are highly standardized and liquidity is always ensured by the exchange that stands as a guarantor of performance. Both instruments are used for protecting asset positions held and also for pure speculation. In India, both futures and options expire on the last Thursday of every month.  That’s the similarity. Now to the differences:

PAYMENT OF PREMIUM / MARGIN.

Futures contract does not require the payment of a premium by the buyer to the seller. Instead, for futures, an amount needs to be kept with the broker called margin money. Since futures are settled on daily basis, the margin money will have to be provided accordingly. Both the buyer and the seller of a futures contract have to keep margin money with the broker. Whereas in the case of options, an amount called premium will be paid by the buyer to the seller. In other words option writing is a way to make some money for option sellers. Only the seller of an option is required to give margin to the broker.

THE OBLIGATIONS PART

A future contract obligates the buyer to buy the underlying asset on expiry at a pre determined price. The obligation is definite.  But in the case of option buyers, they are not obliged. They would buy the underlying asset only if the market movement is favorable to them. For enjoying this luxury, they have already paid a sum by way of premium to the sellers. In case they don’t exercise the option, the premium is not paid back by the sellers, it’s lost.

The seller of a futures contract is also obligated in the same manner. He is supposed to sell the asset at a predetermined price whatever may come. Similarly the writer of a call is also obliged to sell the asset at a predetermined price. The difference lies in the fact that the seller of futures contracts doesn’t earn anything in the Deal. But the writer of a call collects the premium from the seller.

From the obligations part, futures are more destructive than options since the obligation in the case of former is already fixed.

LIABILITY

If the price moves against a futures participant, his liability is literally unlimited unless he cuts his position in between. However, buyers of stock options lose only the premium paid in case the price of the underlying asset moves against them.

RISK AND UNDERSTANDBILITY.

As far as the risk part is concerned, futures are more risky than options. The risk arises in futures due to the fixed obligation part. The futures trade must be closed by the trader at expiry and cannot be left just like that. As far as options are concerned, if you don’t what to exercise the option, you can forget about it. there are no more formalities.

As far as understanding the intricacies are concerned, futures are far simpler to understand, but options, when compared to futures may seem to be complicated for a fresher.

These are the main difference between futures and options. That was just a quick reminder. There is a lot more to discuss in options.

You may like these posts:

  1. Options: Kick off
  2. Options: Premium
  3. Types of derivatives 2 – Futures contract

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