Derivatives are financial products that derive their value from an underlying asset like shares, commodity, or currency. Options and futures are two common instruments traded in the derivatives segment.
Futures are contractual agreements between parties to sell or purchase the underlying asset at a certain price at a specific time in the future. These contracts are beneficial for investors who do not have the entire amount to fulfill the agreement at the time of entering into it. Traders often use futures contracts for arbitrage. It implies that the traders purchase the underlying asset at a lower spot price and sell it for a higher value in the futures market or vice versa. The primary objective is to earn profits through the price differences that exist between the cash and futures market.
Options are contracts that offer parties the right without the obligation to fulfill the agreement. Buyers may choose to let the option contract to lapse on the expiration date. However, sellers must comply with the terms if the buyers choose to execute their options.
Options are classified into two types; put and call options. A put option offers buyers the right to sell and a call option the right to buy the agreed quantity of the underlying asset at the predetermined price on or before the expiration date.
Difference between options and futures
1. Obligation of the parties
The most fundamental difference between futures and options is the obligation of the contracts on the buyers and sellers. Options offer buyers the right to sell or buy the underlying asset at the agreed price before the end of the contract. On the other hand, buyers and sellers of a futures contract are obligated to buy or sell the underlying asset on the agreed future date at the pre-determined price.
2. Quantity of the underlying asset
Generally, futures contracts include large quantities of the underlying assets. In comparison, the quantities are lower in an options contract.
3. Upfront premium amount
Investors may enter into a futures contract with no upfront premium except the commission. However, options contracts require the payment of a premium. This is the fee paid by the buyers to enjoy the privilege of not having an obligation to fulfill the contractual terms in case the price of the underlying moves in an adverse direction.
4. Potential gains
Profits from an options contract may be earned by exercising it if the price of the underlying asset is favorable, taking an opposite position in the market, or waiting until the expiration date to profit from the difference between the spot and strike prices. In comparison, the profits on futures contracts are automatic ‘mark to market’. This means the potential gains vary based on the closing price at the end of each trading session.
Generally, options trading are used by hedgers to hedge their risks. Futures are often used by arbitrageurs and speculators who want to make money through the difference between the spot price and strike price.