The futures and options are the derivative instruments utilised by the investors for the purpose of hedging and speculation. Both futures and options are publicly traded in the stock exchange to hedge the risk of loss due to the price movement of stocks and sometimes to make profits from such fluctuations of the stock market.
In this article, we will understand what does it mean by future and option as well as the difference between futures and options. But before we go ahead, let us understand first the fundamentals of derivatives in the stock market.
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Futures and Options:
To understand the concept of futures and options, we need to clarify the basic meaning of derivatives.
The derivatives are the financial instruments which don’t have their own value instead their value is derived from the underlying assets. The underlying assets may be stocks, commodities, currency, indices etc. Now let’s discuss what does it mean by future and option.
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The Futures refers to the derivative financial contract between two parties that obligate both the parties to transact the assets at a future specified date and predetermined price. The futures contract has a fixed expiry dates such as near month expiry, next month expiry and for month expiry. Both parties have to fulfil their commitment on or before the expiry dates.
The assets may be stocks, commodities, or currency and predetermined date shall be decided at the time of formation of such contract.
Let’s understand the above theory with an example.
- Suppose there are two-person Mr A and Mr B and A holds the 1000 shares of L&T Ltd whose current market price is Rs 1500/- per share (say).
- Now Mr A predicts that market price of L&T shares could be depreciated in next 3 months, on the other hand, according to Mr B, the share price of L&T ltd is going to appreciate after 3 months.
- Now to hedge the risk associated with a price reduction of shares, Mr A enters a future contract with Mr B, which states that Mr B will be under obligation to buy the 1000 shares of L&T at the rate of 1500/- per share on a predetermined date (After 3 months).
- Thus motive of A as well B has been satisfied because A presumed that his value of portfolio could be decline and Mr B will get the shares at the same price as before so that he can immediately sell the shares in the open market to make a profit.
- Now after 3 months, suppose if the share price of L&T increases by 500, then Mr will purchase the share at 1500 and sell at Rs 2000/-, thus he will make a profit of 500 per share and Mr will suffer a loss of 500 per share.
- Contrary, if the price of share decreases by 500 and hence the current market price is 1000/- per share. But Mr A will still be able to sell it to Mr B at the rate of 1500/- per share. Thus Mr A reduced his loss of 500/- (per share) and Mr B will suffer a loss of 500/- per shares as he can purchase those share at 1000/- from open market instead of buying from Mr A.
- Thus future contracts facilitate both parties to reduce their losses, thus loss of one party is the gain of other parties.
On the other hand, Options are also financial derivatives refers to the financial contract which provides an option/ liberty (not the obligation) either to perform or forfeit trading of assets at future specified date/ expiry. To purchase an options contract of any stocks or commodity or currency, one has to pay some premium upfront and the prices increases with the duration of expiry.
The futures and options of each stock are listed in the stock exchange along with all details like expiry date, quality, price and traded frequently among investors/ spectators to make gains.
Let’s consider the above example once again.
- Suppose Mr A enters a put option contract by paying a premium of 20/- per shares (means 20,000/- for 1000 shares). Thus A has the right to sell entire shares at the rate of 1500/- per share to Mr B.
- Now suppose if the market price of shares goes down to 1000/- per share, he can still sell it at 1500/-, in this case, Mr A will exercise the option contract to recover loss of Rs 500/- per share.
- But if the market appreciates and shares price increases to Rs 2000/-, in this case, Mr A will not exercise the contract as he can sell his shares at a higher price in the open market. Therefore, unlike futures, options contract doesn’t provide compulsion to exercise the contract, he can or can’t perform the contract according to his interest.
Futures vs Options (Comparison Table):
|BASIS OF COMPARISON||FUTURES||OPTIONS|
|MEANING||The futures are the derivative financial contract which gives an obligation to trade (sell or buy) the underlying asset on future specified date at a predetermined price.||The options are those financial derivative contracts which provides rights/option (Rather than compulsion) to sell or buy the underlying assets
on future specific date at a predetermined price.
|UPFRONT PREMIUM||Not required||Required|
|Buyer/ Seller's Obligation||Buyer and Seller are bound to perform transaction as per contract on expiry date.||Option holder have rights whether to exercise the contract or not on or before expiry date.|
|Can transaction be done before expiry date?||NO||YES|
|Profits/ loss Probability||High||Low|
Now let us discuss what exactly is the difference between futures and options.
Difference between Futures and Options:
- The main difference between future and option is that a future contract imposes an obligation/ compulsion to perform transaction of mentioned assets at the expiry date, on the other hand, option contract doesn’t impose any compulsion to exercise the contract on the expiry date.
- The futures don’t require an upfront premium whereas options contract require an upfront (Advance) premium.
- In case of futures, the transaction of financial assets can’t be done before the expiry date, however, in option contracts the rights which a buyer or seller has, can exercise even before the date of expiry.
- The probability of making a profit as well as suffering a loss is more in futures because of compulsion/ obligation of contract on the date of expiry, on the other hand, the chances of loss are less and fixed and chances of profit is also less as compared to a future contract.
- Thus we can say the futures are riskier than options.
Hope you would have understood the difference between futures and options and their fundamentals as well. In fact, both futures and options are the most popular types of derivatives which are frequently traded in the majority of stock exchanges.
In a nutshell, we can distinguish future and option as compulsion and liberty of performance of the contract by both parties at the future specified date. In case of the futures contract, both parties bound to exercise the terms as per the contract whereas in option contracts it is the buyer’s interest whether to buy the underlying asset or not.
Reference: Future vs option Investopedia (source)