Differences Between Futures and 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.
The derivatives market is the financial market for derivative instruments that derive their value from an underlying value of the asset. The contracts categorized under derivatives are:
- Forwards Contract
- Futures Contract
- SwapsSwapsSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.
Futures contracts are agreements for trading an underlying asset on a future date at a predetermined 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 two types of options: Call Options and Put Options, which will be discussed in detail.
Future vs. Option Contract Infographics
Let’s see the top differences between futures vs. options contracts.
There are a number of similarities which exist between these contract which keeps the basics intact:
- Both are exchange-traded derivatives traded on the stock exchangesThe Stock ExchangesStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ. 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.
- 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.
- Since the 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 the security.
- 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.
- 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.
- 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.
- No factor of time decay is important in futures contract since the contract is definitely going to be executed. Whether the option contractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised. will be executed will be much clearer while coming closer to the date of expiry, thus making time value of moneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment. an important factor. The premium amount paid also considers this factor during calculations.
- The fee associated with futures trading is easier to understand since most of the fees remain constant and include commissions on the trade, exchange fees, and brokerage. Other expensesOther ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities. 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 assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. 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.
Futures vs. Options Comparison Table
|Basis of Comparison||Futures||Options|
|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 is 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||It is 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||It is paid in the form of a premium, which is a small percentage of the entire amount.|
|The 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|
As discussed above, both are derivatives contractsDerivatives ContractsDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based. having its customization as per the requirements of the counterparties. Options contract can reduce the number of losses, unlike futures contracts, but futures offer the security of a contract getting executed at a certain date.
The objective is to protect the interests of the initiator of the contract while speculating the direction of the prices. Accordingly, the buyer and seller can enter into a contract depending on the risk-taking ability and trust in their intuition. Since futures involves the presence of an exchange, the execution of the contract is likely, whereas options do not have such an option, but on the payment of a premium amount, one can lock in the contract and depend on where the direction of prices are towards the end of the duration, the contract can either be executed or allow expiring worthless.
This has been a guide to Futures vs. Options. Here we discuss the differences and similarities between the two with infographics and a comparison table. You may also have a look at the following articles to learn more –