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Explore the differences between futures and options in trading to better understand their role in speculation, hedging, and diversifying your portfolio.
Futures and options (F&O) are two of the most widely used derivative instruments in the stock market. They provide you, as investors and traders, with tools to manage risk and speculate on price movements. Although they share similarities, there are differences between futures and options.
Futures and options differences may be understood in terms of obligations, risk profiles, and operational mechanics. By understanding how F&O functions and what sets them apart, you can make better investment choices.
Futures in trading are standardised contracts that enable the transaction of assets at a predetermined price. They are used for hedging risk against price movements in commodities, currencies, and instruments.
Futures contracts are legally binding agreements to buy or sell an underlying asset. This can be done at a predetermined price on a defined future date. Stock exchanges standardise and list them for trading, ensuring regulation and transparency.
Key Features of Futures Contracts
Futures contracts have several distinct features, including:
Standardisation: Contract sizes and expiration dates are standardised by stock exchanges
Obligation: Both buyer and seller are obligated to fulfil the contract at maturity
Margin Requirements: Traders must maintain margin accounts to cover potential losses
Settlement: Can be physical delivery or cash settlement, depending on the contract
Diverse Asset Classes: Allows trading in various assets like stocks, currencies, and commodities
Risk Control: Help hedge against price fluctuations in the underlying asset
Expiry Date: Each futures contract has a set expiry date by which the trade must be executed
Mark-to-market: Exchanges settle futures positions daily and adjust profits and losses accordingly
Market participants use futures for:
Hedging: Protecting against price fluctuations in commodities, currencies, or equities
Speculation: To enable profit from expected price movements
Price Discovery: To discover prices and market signals for underlying assets
Securing: Securing commodities for delivery in future
Options are contracts that give you the right, and not the obligation, to make a transaction. They are widely used for speculating on market movements with limited capital exposure.
You can buy or sell the asset at a pre-determined strike price before or on a particular expiration date using options contracts. Sellers of options, however, must fulfil the contract if exercised.
Options have unique characteristics and advantages, such as:
Options are commonly used for:
Futures and options trading are both derivative instruments. However, they differ significantly in structure, risk, and obligations. Here are some differences:
Futures contracts require both parties to fulfil the contract terms at expiration. Options give buyers the right without obligation, providing flexibility.
Futures expose traders to potentially unlimited gains or losses. On the other hand, options buyers risk only the premium paid, with unlimited profit potential (calls) or limited to the asset value (puts).
Options require the payment of a premium upfront, which is non-refundable. On the other hand, futures do not have a premium but require margin deposits.
Futures settle on the expiry date either by delivery or cash. You can exercise options at expiry day.
Examples Comparing Futures and Options
Here are some examples that may make it easier for you to compare the two:
Trading futures vs options involves distinct strategies, risk levels, and capital requirements. Here are some detailed trading characteristics of both:
Futures markets tend to have higher liquidity due to standardised contracts. On the other hand, options markets can be less liquid, especially for less popular strike prices. Options provide strategic stability, making them perfect for hedging against market volatility.
Futures require margin maintenance, as it is a large volume contract. Options require payment of premiums but less upfront capital. Overall, futures are cheaper than options.
Futures may appeal to traders with higher risk tolerance and capital. Options offer flexibility and risk-limiting features suitable for a wider range of investors. However, both these options carry specific risks.
Now that you can compare the benefits and features of option trading vs future trading, understanding these risks is crucial.
Both instruments carry exposure to price volatility that can lead to gains or losses.
The use of leverage magnifies profits and losses, with futures typically requiring a higher margin than options.
Options lose value as expiration approaches, known as theta decay. It affects the profitability of the contract.
Low trading volume in some F&O contracts can cause difficulty in entering or exiting positions. It can result in higher transaction costs.
If traders are unprepared for the physical delivery of shares, they may face fund shortages or delivery issues.
Inadequate knowledge of F&O strategies can lead to poor decisions and heavy financial losses.
Futures and options are powerful derivatives with features suitable for different trading needs. Understanding their obligations, costs, risks, and uses is essential to navigate the market and make informed decisions.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
Sources
Securities and Exchange Board of India (SEBI): https://www.sebi.gov.in/
National Stock Exchange of India (NSE): https://www.nseindia.com/
Bombay Stock Exchange (BSE): https://www.bseindia.com/
Investopedia: https://www.investopedia.com/
Futures contracts are contracts to buy or sell an asset at a set price on a future date, obliging both parties to honour the contract terms.
Options contracts grant you the right to buy or sell an asset at a set price before expiry by paying a premium. You can exit the offer if you do not wish to continue, but the seller is obligated if exercised.
Risks include market volatility, leverage effects, time decay for options, liquidity risk, and more. All of them can lead to significant financial losses.
Both serve risk management, but differ in approach. Futures lock in prices, obliging contract fulfilment. Options provide the right to hedge with limited downside risk. Futures may be riskier than options, but suitability depends on individual preferences.
