Options and futures are derivatives contracts that allow traders to speculate on underlying asset prices. While both give traders exposure to price movements of the underlying without actually owning it, there are important differences between options and futures. In this article, we will explain the key difference between options and futures - what they are, how they work and their unique pros and cons.
Understanding the difference between options and futures is vital because they are two different types of derivatives. There are a few key reasons why understanding the difference between options and futures is essential:
- Flexibility - Options give you more flexibility since you can exercise or not. Futures contracts are binding agreements that must be fulfilled.
- Leverage - Futures provide more power since you only need to add a small portion of the contract value as a margin. Options have lower leverage.
- Contract specifications - Options and futures have different contract specifications like expiration dates, contract sizes, underlying assets, etc. Understanding these differences is important.
- Trading strategies - Different trading strategies work best for options vs futures. Knowing which strategies match each instrument type helps maximize returns.
- Regulatory differences - Options and futures are regulated differently and have different margin requirements and reporting obligations.
So in short, options and futures are distinct types of derivative contracts with different risk profiles, specifications, strategies, and regulations. Understanding the key differences between them is important to properly evaluate which instrument is better suited for your investment or hedging needs.
Difference Between Options and Futures
|Options grant the owner the privilege, but not the duty, to purchase or sell an underlying security or asset at a predetermined price||Futures are contracts that obligate the holder to buy or sell an underlying asset at a specified price on a certain date.|
|Options have two types: call options and put options.||Futures have only one type.|
|Options are more flexible and customizable than futures.||Futures are more standardized and regulated than options.|
|Options can be exercised anytime before expiration (American style) or only at expiration (European style).||Futures can be settled by delivery of the underlying asset or by cash settlement at expiration.|
|Options have a premium that is paid by the buyer and received by the seller.||Futures have no upfront payment but require a margin deposit by both parties.|
|Options have limited risk for buyers and unlimited risk for sellers.||Futures have an unlimited risk for both buyers and sellers.|
|Options have unlimited profit potential for buyers and limited profit potential for sellers.||Futures have unlimited profit potential for both buyers and sellers.|
|Options are affected by time decay, which reduces their value as expiration approaches.||Futures are not affected by time decay but by changes in the underlying asset price.|
|Options are more suitable for hedging and speculation than futures.||Futures are more suitable for arbitrage and price discovery than options.|
|Options can be exercised early or lapsed without any obligation.||Futures must be fulfilled or closed before expiration.|
|Options have lower liquidity and volume than futures.||Futures have higher liquidity and volume than options.|
|Options have higher transaction costs and commissions than futures.||Futures have lower transaction costs and commissions than options.|
|Options can be used to create complex strategies with multiple legs.||Futures can be used to create simple strategies with one or two legs.|
|Options are more sensitive to changes in volatility than futures.||Futures are more sensitive to changes in interest rates than options.|
|Options can be based on stocks, indices, commodities, currencies, etc.||Futures are often based on commodities but also on stocks, indices, currencies, etc.|
|Options have a strike price, which is the predetermined price at which the contract can be exercised||Futures have a delivery price, which is the agreed price at which the contract will be settled at expiration|
|Options have an intrinsic value, which is the difference between the underlying asset price and the strike price if it is positive||Futures have no intrinsic value but only a market value, which is determined by the supply and demand of the contract|
|Options have an extrinsic value, which is the difference between the option premium and the intrinsic value, if any||Futures have no extrinsic value but only a fair value, which is based on the cost of carry of the underlying asset|
|Options can be classified as in-the-money, at-the-money, or out-of-the-money, depending on the relationship between the underlying asset price and the strike price||Futures can be classified as in backwardation or contango depending on the relationship between the spot price and the future price of the underlying asset|
Difference Between Future and Options (Time-Based)
|Type||Market||Trading Time||Contract Cycle||Expiration Date||Settlement Mode|
|Options||Equity Options||NSE/BSE||9:15 a.m. to 3:30 p.m.||Three-month contracts||Last Thursday of every month||Cash or delivery|
|Currency Options||NSE/BSE||9:00 a.m. to 5:00 p.m.||Three-month contracts||Two working days before the last working day of every month||Cash|
|Commodity Options||MCX||10:00 a.m. to 11:30 p.m./11:55 p.m.*||Different contract cycles depending on the underlying commodity||Three days before the first day of the delivery month||Cash or delivery|
|Futures||Equity Futures||NSE/BSE||9:15 a.m. to 3:30 p.m.||Three-month contracts||Last Thursday of every month||Cash or delivery|
|Currency Futures||NSE/BSE||9:00 a.m. to 5:00 p.m.||Twelve-month contracts||Two working days before the last working day of every month||Cash|
|Commodity Futures||MCX||10:00 a.m. to 11:30 p.m./11:55 p.m.*||Different contract cycles depending on the underlying commodity||A specific date of every month||Cash or delivery|
Futures vs Options: Which is Better for You? In-Depth Analysis
Futures and Options have different characteristics, risks, and rewards that investors should understand before choosing which is better. The main difference between futures and options is that futures oblige the buyer and the seller to execute the contract at a specified price and date, while options give the buyer the right but not the obligation to do so. This means that futures have higher risk, lower flexibility than options, lower transaction costs, and higher liquidity.
To illustrate these differences, let’s look at the example of futures and options trades:
Example: An investor expects the price of ABC stock to rise from ₹100 to ₹120 in three months. He can either buy a three-month futures contract for 100 shares of ABC at ₹100 per share or buy a three-month call option for 100 shares of ABC with a strike price of ₹100 and a premium of ₹5 per share.
- If he buys the futures contract, he will pay nothing upfront but must deposit a margin of ₹2,000 (20% of ₹10,000) with his broker. If ABC rises to ₹120 at expiration, he will profit ₹2,000 (₹20 x 100) minus commissions and fees. If ABC falls to ₹80 at expiration, he will lose ₹2,000 (₹20 x 100) plus commissions and fees. He may also face margin calls or forced liquidation if ABC falls below his maintenance margin level before expiration.
- If he buys the call option, he will pay ₹500 (₹5 x 100) upfront as a premium plus commissions and fees. If ABC rises to ₹120 at expiration, he will exercise his option and make a profit of ₹1,500 (₹20 x 100 - ₹5 x 100) minus commissions and fees. If ABC falls to ₹80 at expiration, he will let his option expire worthless and lose only his premium of ₹500 plus commissions and fees.
This example shows that futures and options have different risk-reward profiles that suit different types of investors and market scenarios. Futures are better for investors who have a strong conviction about the direction and magnitude of the price movement and are willing to take on more risk and less flexibility. Options are better for investors with a moderate or uncertain outlook about the price movement and looking for more flexibility and less risk.
In this article, we covered the key differences between options and futures contracts. We discussed what each type of derivative is, how they work, and their unique benefits and risks. With this information, you should now be able to decide which contract suits your investing objectives, risk appetite and market outlook - options or futures.
Whichever you choose, it is important to trade through a reputable and reliable broker. That’s why we recommend Samco as your preferred broker for trading options and futures. You can open a free account with Samco today and start trading with ease and convenience. Click here to sign up with Samco and start your journey to financial freedom.