DIFFERENCES BETWEEN FUTURES VS OPTIONS

The derivatives market is the financial market for derivative instruments which derive their value from an underlying value of the asset. The contracts categorized under derivatives are:

?Forwards Contract

?Futures Contract

?Options

In this article, we will discuss the importance of Futures and Options and the role they play in the functioning of the derivatives market.

?Futures Contracts are agreements for trading an underlying asset on a future date at a pre-determined price. These are standardized contracts traded on an exchange allowing investors to buy and sell them.

?Options contracts, on the other hand, are also standardized contracts permitting investors to trade an underlying asset at a pre-decided price and date (expiry date for options). There are 2 types of options: Call Options and Put Options which will be discussed in detail.

Futures and Options Similarities

There are a number of similarities which exist between Futures and Options contract which keeps the basics intact:

?Both are exchange-traded derivatives traded on the stock exchanges around the world

?Daily settlement takes place for both contracts

?Both contracts are standardized with a margin account applicable

?The underlying asset governing these contracts is financial products such as Currencies, Commodities, Bonds, Stocks etc.

Futures and Options differences

Let us have a look at the differences applicable to Futures and Options in detail:

1. A futures contract is an agreement binding on the counterparties for buying and selling of financial security at a predetermined price at a specific date in the future. On the other hand, an Options Contract allows the investor the right but not the obligation to exercise buying or selling of a financial instrument on or before the date of expiry.

2. Since futures contract is binding on the parties, the contract has to be honored on the pre-decided date and the buyer is locked into the contract. Subsequently, an option contract provides just the option but no obligation for buying or selling of the security.

3. For securing a futures contract, apart from the commission amount paid no advance payments are considered as compared to an options contract which makes it essential to make a premium payment. This is done for the purpose of locking the commitment made by the parties.

4.The execution of the futures contract can only be done on the pre-decided date and as per the conditions which have been mentioned. Options contract requires the performance to be done at any time prior to the date of expiry.

5.A futures contract can have no limits amounts of profits/losses to the counterparties whereas options contract have unlimited profits with a cap on the number of losses.

6.No factor of time decay is important in futures contract since the contract is definitely going to be executed. Whether an option contract will be executed will be much clearer while coming closer to the date of expiry, thus making time value of money an important factor. The premium amount paid also considers this factor while calculations.

7.The fee associated with futures trading is easier to understand since most of the fees remain constant and includes Commissions on the trade, exchange fees and brokerage. Other expenses pertaining to margin calls are also involved which also does not change much.

In options trading, the options are either trading at a premium or a discount offered by the seller of the option. These can significantly vary depending on the volatility of the underlying asset and are never fixed. Higher premiums are usually tied to more volatile markets and even assets that are priced less expensive can see the premiums rise when the markets head into a period of uncertainty.

Meaning Agreement binding the counterparties to buy and sell a financial instrument at a predetermined price and a specific date in the future. A contract allowing the investors the right to buy or sell an instrument at a pre-decided price. It is to be executed on or before the date of expiry.

Level of Risk High Restricted to the amount of premium paid.

Buyer’s Obligation Full obligation to execute the contract There is no obligation

Seller’s Obligation Complete obligation If the buyer chooses then the seller will have to abide by it.

Payment in Advance No advance payment to be made except commission Paid in the form of premium which is a small percentage of the entire amount.

Extent of Gain/Loss No Restriction Unlimited Profits but limited loss

Date of Execution On the pre-decided date as per contract Any point of time before the date of expiry.

Time Value of Money Not Considered Relied heavily upon