Futures vs Options A Comprehensive Comparison

Options and futures are both derivatives traded on stock exchanges in the Indian financial markets. Before you begin participating in this market segment and start futures and options trading, you need to get a better idea of what these derivatives are and how they differ from one another.

What are Futures?

 A futures contract is an agreement between two parties to trade an underlying asset at a predetermined price, on a specific date (known as the expiration date). Each party entering into the futures contract is obligated to fulfil their end of the agreement upon expiry. Stock exchanges levy a penalty on the parties that do not uphold their end of the contract.  

What are Options?

 An options contract, like a futures contract, is also an agreement between two parties to trade an underlying asset on a specific date at a predetermined price (known as the strike price). However, the fundamental difference is that, unlike a futures contract, an options contract gives the option buyer the right (and not the obligation) to trade in the underlying asset.

The options buyer can choose to not exercise their right upon expiry. In that case, the contract would expire worthless. The options seller, however, is contractually obligated to fulfil their end of the contract if the buyer chooses to exercise their right.

There are two kinds of options contracts — call options and put options.

In a call option, the option buyer gets the right to buy the underlying asset at the strike price on expiry. However, in a put option, the option buyer gets the right to sell the asset at the strike price on expiry.

Comparing Futures and Options 

Now that you have understood the fundamentals of these two types of derivatives, let’s get into the details of comparing futures and options.

Right vs. Obligation

Both the buyer and the seller of a futures contract are obligated to fulfil their end of the agreement. However, in the case of options, only the options seller is obligated by the contract. The options buyer may choose to either exercise their right or to let the option expire worthless.

Risk Factor

When it comes to the risk factor involved in futures and options trading, futures tend to be slightly riskier than options. This is because both the buyer and seller are obligated to fulfil their end of the agreement, even if it means that the market is moving against them. So, irrespective of whether you have purchased or sold a futures contract, you take on a significant amount of risk.

However, in the case of options, the risk is considerably lower if you are the buyer of the contract. This is because if the market is moving against your expectations, you may choose to not exercise your right. This can help limit your losses.

Margin vs. Premium

 To purchase or sell a futures contract, you will have to deposit an initial margin. The margin is usually a percentage of the trade value and acts as a security deposit to cover the risk taken on by the stock exchange in case of any default from your end. If the market does not move as you expect, you may be asked to deposit an additional margin to keep your futures position open.

On the other hand, if you’re an options buyer, you will only have to pay a nominal amount as premium at the time of purchase. If you’re an options seller, you will receive the premium instead.

Conclusion  

Futures and options trading is quickly becoming very popular in India. Now that you have understood the differences between these two types of derivatives, you can participate in this market segment more confidently. Depending on your trading goals, you can compare futures vs options strategies and plan your entry into and exit from the market accordingly.