Understanding difference between futures & options

Understanding difference between futures & options
Highlights

Futures and options are tools used by investors while trading in the derivative market They represent two of the most common form of derivatives

Futures and options are tools used by investors while trading in the derivative market. They represent two of the most common form of ‘derivatives’. Futures and options contracts can cover stocks, bonds, commodities and even currencies. As financial contracts between the buyer and the seller of an asset, they offer the potential to earn huge profits, but it is pertinent to note the key differences between futures and options. An understanding of the major differences between these two will help us to use these trading tools efficiently.

Futures

  • A future is a contract between two parties to buy or sell an asset at a certain time in future at a specific price.
  • In futures the buyer is obligated to honor contract.
  • A futures contract requires higher margin payment than options.
  • Futures are preferred by speculators.
  • In a futures contract, the holder is bound to buy on the future date even in case of a loss. The buyer will have to but at the price agreed upon earlier and incur losses. In other words, a future contract could bring unlimited profit or loss.
  • When a buyer enters into a futures contract, he agrees to pay an initial amount which is called margin amount.
  • A futures contract is executed on the date agreed upon on the contract.

Options

  • An options contract gives the buyer the right to buy the asset at a fixed price. However, there is no obligation on buyer to actually buy or sell.
  • The buyer in an options contract has an edge over the futures contract holder. If the asset value falls below the agreed upon price, the buyer can opt out of buying it so, the buyer’s loss is limited. Thus, an options contract may bring unlimited profit but it reduces the potential loss.
  • Options is preferred by a hedger. A hedger would reduce his asset exposure to price volatility. Hedgers use the derivatives markets primarily for price risk management of assets and portfolios.
  • Options require lower margin payment than futures. This is called the premium amount.
  • The buyer in options contract can execute the contract any time before the date of expiry. So, if the market in conducive one can buy the asset. Thus, invest wisely in derivatives to reap more benefits financially. (The author is a homemaker who dabbles in stock market investments in free time)
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