A stock market has a variety of investment tools through which investors can trade. This includes derivative products which are investments which derive their value from the value of an underlying asset. These are used by investors and traders who wish to speculate on market movements and enter contracts accordingly to profit in the short term.
This article looks at meaning of and differences between two derivative products – Futures and Options.
Definitions and meanings
Futures:
Futures are financial agreements to buy or sell a specified quantity of a specified underlying asset at a future date at a price agreed upon between the buyer and the seller. Both the buyer and seller are obligated to execute the futures contract on the settlement date.
An example of a futures contract – Buyer A has entered into a future contract with seller B to buy 100 units of stock ABC Ltd at $10 each after 2 months. On the date of execution, the price of the stock has risen to say $12 each. The futures contract will be executed and seller B would be obligated to sell 100 units at $10 even though the market price is $12. This difference of $2 per unit is buyer A’s profit.
Futures operate on leverage i.e., the entire value of the underlying asset is not required to be invested in at the time of buying the future, but only a percentage of it termed as ‘margin’ is required to be invested in.
Options:
Options are financial agreements which give the buyer an option to purchase or sell a specified quantity of a specified underlying asset at a pre-agreed price. The option can be exercised at any time before expiry of the contract.
In an options contract, the buyer of the option has a choice to execute the contract at any time before expiry, whereas the seller is obligated to execute at any time when required by the buyer.
There are 2 types of options:
Call option – option to buy; for example, buyer A buys a call option to buy 100 units of stock ABC Ltd at $10 each 3 months later. If the market price of the stock exceeds $10, the buyer can exercise the call option and the seller will be obligated to sell. If the price falls below $10, the buyer will choose to let the option expire as he can purchase from the open market at a price lower than $10.
Put option – option to sell; for example, buyer A buys a put option to sell 100 units of stock ABC Ltd at $10 each 3 months later. If the price of the stock exceeds $10, the buyer will let the option expire as he can sell his stock in the open market at a price higher than $10. If the price falls below $10, the buyer of the option can exercise the put option and the seller of the put option will be obligated to buy the stock at $10.
Options operate on the basis of premium. The buyer of an option (either call or put) has to pay a premium to the seller of the option as the purchase price of the options contract.
Difference between futures and options:
The difference between futures and options has been detailed below:
1. Meaning
- Futures are financial agreements to trade a determined quantity of a specific underlying asset at a future date at a pre determined price.
- Options are financial agreements which give the buyer of the option, a choice to trade a determined quantity of a specific underlying asset at a pre-determined price, to be exercised at any time before expiry of the agreement.
2. Execution
- Futures are obligations to buy or sell and thus mandatorily have to be executed on the settlement date.
- Options give the buyer an option to execute but cast an obligation on the seller to execute if required by the buyer.
3. Settlement timing
- Futures are settled on pre-decided settlement date.
- Options can be settled at any time before expiry.
4. Cost at the time of entering into contract
- Futures are bought by depositing of ‘futures margin’. This margin is adjusted against the settlement price at the time of execution.
- Options are bought by payment of ‘options premium’. This is paid by the buyer of the option (call or put) to the seller of the option.
4. Profit/loss to buyer
- The buyer in the futures contract will profit when the market price exceeds the futures price on the settlement date. The buyer will lose when the market price falls below the futures price on the settlement date.
- A buyer of call option will profit when the market price exceeds the future price on the settlement date. A buyer of put option will profit when the market price falls below the futures price on the settlement date. A buyer of an options contract will not execute the contract if the market price is not favorable and hence his loss will be limited to the option premium paid.
5. Profit to seller
- The seller in the futures contract will profit when the market price falls below the futures price on the settlement date. The seller will lose when the market exceeds the futures price on the settlement date.
- A seller of call option will lose when the market price exceeds the future price on the settlement date. A seller of put option will lose when the market price falls below the futures price on the settlement date. A seller of an options contract is obligated to execute the contract when favorable to the buyer. The buyer will not execute the contract if it is favorable to the seller, hence the profit of the seller of an options contract is limited to premium received by him from the buyer.
6. Risk
- The risk to both buyer and seller is unlimited in a futures contract.
- In an option, the risk to the buyer is limited to the amount of premium paid, whereas the risk to the seller is unlimited.
Futures versus options – tabular comparison
A tabular comparison of futures and options is given below:
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| Meaning | ||||
| Agreement to buy or sell an underlying asset of pre-determined quantity and at pre-determined price | Agreements which offer the buyer an option to purchase or sell an underlying asset of pre-determined quantity at pre-determined price, at any time before completion of term of the agreement | |||
| Execution | ||||
| Mandatory | Optional for buyer and mandatory for seller | |||
| Settlement timing | ||||
| On predetermined settlement date | At any time before expiry | |||
| Cost at time of entering into contract | ||||
| Margin to be paid. Adjusted at the time of settlement | Premium paid. Not adjusted on settlement. | |||
| Profit/loss to buyer | ||||
| Unlimited – profit on rise in market price and loss on fall in market price | Profit unlimited – call option: on rise in market price, and put option: on fall in market price
Loss limited to premium paid |
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| Profit/loss to seller | ||||
| Unlimited – profit on fall in market price and loss on rise in market price | Profit limited to premium received.
Loss unlimited – call option: on rise in market price, and put option: on fall in market price |
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| Risk | ||||
| Unlimited | Limited for buyer and unlimited for seller | |||
Conclusion:
Futures and options are mostly widely used on the stock market to capitalize on short term trade in stocks and commodities. They are considered fairly risky as they involve speculating on future rise or fall in the market and are thus generally preferred by seasoned traders and investors.
