Derivatives are financial instruments that derive their values from an underlying asset. This may be shares, commodity, debt instrument, or currency. The two common types of derivatives traded are futures and options.
You may not understand the difference between these two types of derivative contracts. However, before knowing the difference, let us understand the meaning of these two instruments.
A futures contract is an agreement between you and another party. Under this contract, the two parties agree to sell or buy the underlying asset at a pre-determined price in the future.
A futures contract is beneficial if you do not have the entire amount needed to buy the underlying asset at the spot price. Often, such contracts are used by traders to benefit from arbitrage. This means that as a trader you may buy the underlying asset at a lower price in the cash market and sell it in the futures market for a higher price or vice versa. The profit is the difference between the spot price and the futures price.
Under the futures contracts, both the seller and buyer must execute the agreement on the expiration date. These are special types of forward contracts and standard exchange-traded agreements.
An options contract offers the buyer the right but not the obligation to perform the agreement. If you are a buyer, you may allow the put or call option to lapse without its performance. The seller has an obligation to execute the contract if you want to exercise your right.
Options are available as put or call. A put option offers buyers the right but not the obligation to sell the specified quantity of the underlying asset at the pre-determined price on or prior to the expiration date.
A call option gives buyers the right without the obligation to buy the specified quantity of the underlying asset at the pre-determined price on or prior to the expiration date.
Difference between options and futures
Having understood what futures and options are, let us understand their difference.
- Unlimited profit or loss potential
As a buyer in the futures market, you have an unlimited potential to earn huge profits. However, the risks are equally high and you may face major losses. However, when you opt for a put or call option, the potential to earn profits is unlimited while the loss is limited, thereby reducing your risk.
- Upfront margin requirements
When you buy a futures contract, you will need to pay a higher upfront margin, which requires more cash flows. On the other hand, options trading does not require higher upfront margin because you only need to pay the premium.
- Obligation to perform
Both parties of a futures contract are obligated to perform the agreement on or before the expiration date. In comparison, options buyers may or may not exercise their rights. However, the seller of the options must perform as per the contract if the buyer decides to exercise his right.
Generally, futures contracts are preferred by arbitragers and speculators. Options are often used by traders who want to hedge their risks against price movements of the underlying asset.
Now that you know the difference between these two types of derivatives, invest today and take advantage of the potential of this market.