Options and futures are two types of derivative products in the stock market. Since they derive their values from an underlying asset, they are called derivatives. They allow investors to speculate on the price movements of an underlying asset, such as a stock, commodity, currency, or index.
However, there are some key differences between them that affect their risk, reward, flexibility, and liquidity.
In this article, we will explain what options and futures are, how they work, and how they compare with each other.
Table of Contents
What are Options?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (called the strike price) on or before a certain date (called the expiration date). The buyer pays a fee (called the premium) to the seller (also called the writer) of the option to acquire this right. The seller receives the premium and agrees to deliver or buy the underlying asset if the buyer exercises the option.
There are two types of options: call options and put options. A call option gives the buyer the right to buy the underlying asset at the strike price, while a put option gives the buyer the right to sell the underlying asset at the strike price. The buyer of a call option expects the price of the underlying asset to rise above the strike price before the expiration date, while the buyer of a put option expects the price of the underlying asset to fall below the strike price before the expiration date.
The buyer of an option can exercise it at any time before it expires or sell it to another investor in the secondary market. The seller of an option can close out their position by buying back the option from another investor in the secondary market or by delivering or buying the underlying asset if they are assigned by the buyer who exercises their option.
Options are traded on standardized exchanges, such as the Chicago Board Options Exchange (CBOE), or over-the-counter (OTC) between private parties. Options have standardized terms, such as strike prices, expiration dates, and contract sizes. For example, one equity option contract typically represents 100 shares of the underlying stock.
Types of Options
There are two primary types of options:
Call Options: A call option gives the holder the right to buy the underlying asset at the strike price or on the expiration date. Call options are used by investors who anticipate the price of the underlying asset to rise.
Put Options: A put option gives the holder the right to sell the underlying asset at the strike price or on the expiration date. Put options are used by investors who anticipate the price of the underlying asset to fall.
Features of Options
Limited Risk: When buying options (both call and put), the most you can lose is the premium paid for the option. This makes options a popular choice for risk-averse investors.
Flexibility: Options can be used in various trading strategies, including covered calls, protective puts, and straddles, to suit different market conditions and investment objectives.
Leverage: Options provide leverage exposure to the underlying asset, allowing traders to control a larger position with a smaller capital outlay. However, this also increases the potential for both gains and losses.
Time Decay: Options have a finite lifespan, and their value erodes as they approach expiration. This is known as time decay, or theta, which can impact option pricing and trading strategies.
Advantages of Options
Limited Risk: As mentioned earlier, the maximum loss for an option buyer is limited to the premium paid.
Diverse Strategies: Options offer a wide range of strategies to profit from various market conditions, including bullish, bearish, and neutral scenarios.
Hedging: Options can be used to hedge against adverse price movements in the underlying asset, reducing overall portfolio risk.
Disadvantages of Options
Premium Costs: Buying options requires paying a premium, which can be substantial, especially for options with longer expiration periods.
Time Decay: Time decay can erode the value of options, making it essential to choose the right time frame for your strategy.
Complex Strategies: Advanced options strategies can be complex and require a deep understanding of market dynamics.
What are Futures?
A futures contract is a contract that obligates the buyer and seller to buy or sell an underlying asset at a predetermined price (called the futures price) on a specific date in the future (called the delivery date). Unlike options, futures do not give any rights or choices to either party; they must fulfill their contractual obligations when the contract expires.
Futures are mainly used for hedging or speculation on the price movements of an underlying asset. Hedgers use futures to lock in a favorable price for their future transactions, such as buying or selling commodities, currencies, or securities. Speculators use futures to bet on the direction of the market, hoping to profit from favorable price changes.
Futures are traded on standardized exchanges, such as the Chicago Mercantile Exchange (CME), or over-the-counter (OTC) between private parties. Futures have standardized terms, such as futures prices, delivery dates, and contract sizes. For example, a gold futures contract typically represents 100 troy ounces of gold.
Types of Futures
Futures contracts can be categorized into various types, including:
Commodity Futures: These contracts involve the delivery of physical commodities, such as oil, gold, or agricultural products, at a future date.
Financial Futures: These contracts are based on financial instruments, such as stock market indices, interest rates, or currencies.
Features of Futures
Obligation: Futures contracts are legally binding, requiring both parties to fulfill the terms of the contract. This can lead to significant financial obligations.
Standardization: Futures contracts are standardized in terms of size, expiration date, and contract terms, making them highly liquid and easily readable on futures exchanges.
Margin Requirements: Futures trading involves margin requirements, where traders are required to deposit a certain percentage of the contract's value as collateral.
Mark-to-Market: Futures positions are marked to market daily, which means gains and losses are settled daily. This helps maintain transparency and reduce counterparty risk.
Advantages of Futures
Liquidity: Futures markets are highly liquid, with a vast number of participants, making it easier to enter and exit positions.
Transparency: Mark-to-market valuation ensures that the true value of a futures position is known at all times.
Hedging: Futures contracts are commonly used for hedging against adverse price movements, providing effective risk management.
Disadvantages of Futures
Obligation: The binding nature of futures contracts means traders can incur substantial losses if market conditions move against them.
Margin Calls: Margin requirements can lead to margin calls, requiring traders to deposit additional funds to cover losses, potentially leading to forced liquidation of positions.
Limited Flexibility: Futures contracts have standardized terms, limiting the ability to tailor contracts to specific needs.
Comparison Between Options and Futures
Here is a summary table that compares some of the main features and differences between options and futures:
A contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date.
A contract that obligates both parties to buy or sell an underlying asset at a predetermined price on a specific date in the future.
The buyer has no obligation to exercise their option; they can let it expire worthless. The seller has an obligation to deliver or buy the underlying asset if assigned by an exercising buyer.
Both parties have an obligation to fulfill their contractual duties; they cannot back out of their positions unless they close them out before expiration.
The buyer has limited risk; they can only lose their premium paid. The seller has unlimited risk; they can lose more than their premium received if the price of the underlying asset moves against them significantly.
Both parties have unlimited risk; they can lose more than their initial margin deposit if the price of the underlying asset moves against them significantly.
The buyer has unlimited reward; they can profit from large price movements in their favor. The seller has limited reward; they can only keep their premium received.
Both parties have unlimited reward; they can profit from large price movements in their favor.
The buyer has more flexibility; they can exercise their option at any time before expiration or sell it in the secondary market. The seller has less flexibility; they can only close out their position by buying back their option in the secondary market, or by delivering or buying the underlying asset if assigned.
Both parties have less flexibility; they can only close out their position by entering into an offsetting contract in the secondary market or by delivering or buying the underlying asset on the delivery date.
The buyer and the seller have to pay a premium, which is determined by the supply and demand of the option in the market. The premium is affected by various factors, such as the price, volatility, time to expiration, and interest rate of the underlying asset.
The buyer and the seller have to pay a margin, which is a percentage of the contract value that acts as a collateral to ensure their performance. The margin is affected by the daily price fluctuations of the underlying asset, and may require additional deposits or withdrawals.
Options have lower liquidity; they depend on the availability of buyers and sellers in the market. Options also have lower trading volume and wider bid-ask spreads than futures.
Futures have higher liquidity; they are standardized and traded on regulated exchanges with high trading volume and narrow bid-ask spreads.
Examples of Options and Futures Options
Options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price or on a certain date. Futures options are options on futures contracts, which are agreements to buy or sell an asset at a fixed price and date in the future.
Some examples of futures options are:
Stock index options, which are options on futures contracts based on a stock index, such as the S&P 500 or the Nifty 50.
Commodity options, which are options on futures contracts based on a commodity, such as gold, oil, or wheat.
Currency options, which are options on futures contracts based on a currency pair, such as the USD/INR or the EUR/USD.
How To Invest in Futures and Options
To invest in futures and options, one needs to have a trading account with a broker that offers these derivatives.
One also needs to have sufficient margin money, which is the amount of money required to open and maintain a futures or options position.
An investor can buy or sell futures and options contracts through the broker’s platform, either online or offline.
Investors can also use various strategies, such as hedging, speculating, or arbitraging, to profit from the price movements of the underlying asset.
Factors to Consider Before Entering Into Futures and Options Trading
Futures and options trading involves high risks and rewards and is not suitable for everyone. Some factors to consider before entering into futures and options trading are:
The volatility of the underlying asset, which affects the price fluctuations of the futures and options contracts.
The liquidity of the market, which affects the ease of buying and selling the futures and options contracts.
The expiration date of the contracts, which determines the time frame of the trade and the potential losses or gains.
The leverage effect, which magnifies the profits or losses of the trade based on the margin money.
The transaction costs, which include the brokerage fees, taxes, and commissions involved in the trade.
Who Should Invest in Futures and Options?
Futures and options trading is suitable for investors who have a high-risk appetite, a good understanding of the market, and a clear trading objective.
Futures and options trading can help investors to:
Hedge their exposure to the underlying asset, by locking in a price or protecting against adverse price movements.
Speculate on the future direction of the underlying asset, by betting on its rise or fall.
Arbitrage on the price differences between the futures and options contracts and the underlying asset, by exploiting the market inefficiencies.
Options and Futures are potent financial tools packed with unique risks as well as rewards. While Futures offer hedging against price fluctuations, Options introduce you to flexibility and risk control. Understanding these instruments properly is crucial before venturing into derivatives trading.
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Q1: What are the advantages of options over futures?
A: Options have some advantages over futures, such as:
Options give the buyer more flexibility and control over their position. They can choose whether to exercise their option or not, depending on their expectations and preferences.
Options have limited downside risk for the buyer. They can only lose their premium paid, while futures can result in large losses if the mаrket moves against them.
Options allow the buyer to leverage their position. They can control a large amount of underlying assets with a small amount of premium paid, while futures require a larger margin deposit.
Q2: What are the disadvantages of options over futures?
A: Options also have some disadvantages over futures, such as:
Options have higher transaction costs than futures. They require paying a premium, which can be expensive and erode their profits.
Options have lower liquidity than futures. They depend on the availability of buyers and sellers in the market, which can affect their price and execution.
Options have time decay. Their value decreases as they approach their expiration date, while futures do not have this effect.
Q3: What are the advantages of futures over options?
A: Futures have some advantages over options, such as:
Futures have lower transaction costs than options. They require paying a margin, which is a fraction of the contract value and can be refunded if the position is closed out before expiration.
Futures have higher liquidity than options. They are standardized and traded on regulated exchanges with high trading volume and narrow bid-ask spreads.
Futures have no time decay. Theіr value depends only on the price of the underlying asset, while options lose value as they approach their expiration date.
Q4: What are the disadvantages of futures over options?
A: Futures also have some disadvantages over options, such as:
Futures have higher risk than options. They obligate both parties to buy or sell an underlying asset at a predetermined price on a specific date in the future, regardless of their expectations or preferences.
Futures have unlimited downside risk for both parties. They can result in large losses if the market moves against them, while options limit the loss for the buyer to their premium paid.
Futures have less leverage than options. They require a larger margin deposit to control a similar amount of underlying asset, while options allow the buyer to control a large amount of underlying asset with a small amount of premium paid.
Q5: How are options and futures priced?
A: Options and futures are priced differently based on their characteristics. Options are priced using various models, such as the Black-Scholes model or the binomial model, that take into account various factors that affect their value, such as the price, volatility, time to expiration, interest rate, and dividend yield of the underlying asset.
Futures are priced using the cost-of-carry model or the arbitrage-free model, which takes into account the relationship between the spot price (the current market price) and the futures price (the agreed-upon price) of the underlying asset, as well as the cost of storage, transportation, and interest on the underlying asset.
Q6: How are options and futures taxed?
A: Options and futures are taxed differently depending on the type of contract, the holding period, the underlying asset, etc. In general, options and futures are subject to capital gains tax, which is the tax on the difference between the selling price and the buying price of a contract.
Capital gains can be classified as short-term or long-term, depending on how long the contract is held. Short-term capital gains are taxed at ordinary income tax rates, while long-term capital gains are taxed at lower rates. However, there are some exceptions and special rules for certain types of options and futures, such as index options, commodity futures, section 1256 contracts, etc. Therefore, it is advisable to consult a tax professional before trading options or futures.
Q7: How can one trade options and futures?
A: One can trade options and futures by opening an account with a broker-dealer that offers these services. The broker-dealer will provide access to various trading platforms, tools, resources, etc. to help in executing orders, analyzing markets, managing risks, etc. However, one should also do their own research, education, planning, etc., before trading options or futures.
Trading options and futures involves high risk and requires knowledge, skill, discipline, etc. Therefore, one should only trade with money that they can afford to lose and seek professional advice if needed.
Q8: What are some similarities between options and futures?
A: Some similarities between options and futures are:
Derivatives: Options and futures are both derivatives that derive their value from an underlying asset.
Leverage: Options and futures both offer leverage, which means that a small amount of money can control a large amount of assets.
Margin: Options and futures both require margin, which is a deposit of money or collateral to cover potential losses.
Settlement: Options and futures both have settlement, which is the process of transferring the ownership or delivery of the underlying asset or cash at the end of the contract.
Q9.How do I get started with options and futures trading?
A: To start trading options and futures, educate yourself about them. You can then open an account with a brokerage firm that offers derivatives trading. It is essential to develop a trading plan and set risk management strategies. Finally, continuously monitor the markets and stay informed about economic and financial news that can impact your trades.
Q10: How are options and futures priced?
A: Options and futures are priced differently based on various factors.
The price of an option is determined by its intrinsic value and its time value. The intrinsic value is the difference between the strike price and the current price of the underlying asset, if it is profitable. The time value is the amount that the option buyer is willing to pay for the possibility of future profit, based on the volatility, interest rate, dividend, etc.
The price of an option is also affected by its supply and demand in the market.
The price of a future is determined by the spot price of the underlying asset, adjusted for the cost of carry. (The cost of carry is the net cost or benefit of holding the underlying asset until the delivery date, including interest, storage, insurance, etc.)
The price of a future is also affected by its supply and demand in the mаrket.
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