Difference Between Futures and Options

Understanding what futures and options are, and more importantly, how they differ from each other, is essential for anyone exploring trading or investing in financial markets.

Futures are standardised contracts that create an obligation for both buyer and seller to complete the transaction at a predetermined price and date. Options, on the other hand, provide the holder with a right but not an obligation to buy or sell an asset within a specific period.

Knowing these differences allows investors and traders to choose strategies that match their goals and risk tolerance. For instance, futures may suit those seeking direct exposure, while options offer flexibility and controlled risk. Having clarity on these aspects helps in making informed decisions. However, if you are particularly interested in understanding the difference between covered and naked option contracts, you can explore that in detail here.

Key Highlights

• Futures trade needs to be exercised on or before the expiration date.

• Regarding options, the buyer gets rights, not compulsion to exercise the contract before expiration.

• The value of futures and options contracts is based on the underlying assets.

Understanding Futures

Futures represent a derivative contract with an agreement to purchase or sell an underlying commodity, or financial assets at a predetermined future date for an agreed-upon price. These contracts, commonly referred to as "futures," are actively traded on futures exchanges such as the CME Group and necessitate using a brokerage account with approval for futures trading.

A futures contract involves both a buyer and a seller, mirroring the structure of an options contract. Unlike options, which may lose their value upon expiration, the conclusion of a futures contract obligates the buyer to acquire and take possession of the underlying asset. At the same time, the seller is compelled to provide and deliver the underlying asset.

Understanding Options

The term option denotes a financial tool linked to the value of underlying securities like stocks, indices, and exchange-traded funds (ETFs). Individuals holding an options contract can buy or sell the underlying asset, depending on the contract type, without an obligation to do so, distinguishing it from futures.

An options contract has a defined expiration date, by which the holder must decide whether to exercise it. The specified price in an option is referred to as the strike price. Transactions involving options commonly take place through online or retail brokers.

Options vs Futures - Which is Better?

The table below provides a thorough comparison of options and futures.

Key Differences Between Futures and Options

Here is how futures differ from options:

• Nature of Obligation: A futures contract imposes a strict obligation on both buyer and seller to execute the contract on the predetermined date, regardless of price movement. The buyer must purchase, and the seller must deliver, at the agreed price. This binding nature makes futures riskier but straightforward. Options, on the other hand, give the buyer a choice without compulsion. The holder can decide whether to exercise the contract or let it expire worthless.

• Upfront Cost Structure: Entering a futures contract requires posting margin, which is a fraction of the total value, rather than an upfront payment. Margins are adjusted daily through mark-to-market settlements, ensuring positions remain funded. This minimises default risk but ties up capital until the contract ends. Options require buyers to pay a premium at the outset, representing the maximum potential loss. This premium is non-refundable, but no additional margin is needed for holders.

• Risk Exposure: Futures create symmetric risk exposure for both parties. Gains or losses are potentially unlimited since prices can rise or fall significantly, and both sides must settle daily. Neither buyer nor seller has a protective cap. In contrast, options provide asymmetric exposure. The buyer’s risk is limited to the premium paid, while potential profit can be significant depending on price movement. The seller, however, faces high or unlimited risk depending on the contract type.

• Profit Potential: Futures contracts offer linear profit potential, where gains or losses mirror every price movement above or below the agreed contract price. A ₹1 change in the asset’s value leads to the same gain or loss per unit for both sides. This direct relationship makes futures efficient for hedgers and speculators seeking exposure to underlying prices. Options, however, have non-linear profit profiles. The buyer gains only if the price moves favourably beyond the strike plus premium, while losses remain capped at the premium.

• Use in Hedging: Institutions and producers widely use futures for hedging against adverse price movements in commodities, currencies, or interest rates. A farmer, for example, can lock in a future selling price for crops, ensuring predictable revenue. The hedge is exact and compulsory at settlement. Options provide hedging with flexibility, allowing protection against adverse moves while preserving upside potential. An importer may buy a currency option to guard against unfavourable exchange rates but still benefit if rates move positively.

Which one should you choose: Futures Or Options?

Futures provide direct exposure with higher risk, while options offer strategic flexibility and limited risk. A diversified approach may incorporate both instruments based on specific investment goals and market conditions. Futures involve higher risk due to the obligation to buy or sell. Options, with their non-binding nature, offer limited risk.

Confidence in market direction may favour futures, while uncertain or range-bound markets might be better suited for options. The choice between futures and options hinges on the investor's risk appetite, market sentiment, and desired strategies.

Who Should Invest in F&O Trading?

F&O trading is ideal for the following types of traders/investors:

• Individuals with strong knowledge of market trends and technical analysis who can handle volatility.
  
• Investors who are comfortable with substantial risks in pursuit of higher potential returns.
  
• Businesses or investors looking to safeguard portfolios or physical holdings against adverse price movements.
  
• Traders who seek to capitalise on price swings over days or weeks rather than long-term investments.
  
• Those with sufficient capital to handle margin requirements and absorb potential losses.
  
• Market participants who actively track economic indicators, corporate actions, and global events influencing prices.
  
• Investors aiming to balance traditional equity holdings with derivative exposure for portfolio optimisation.
  

Risk Management in Futures and Options Trading

Here are some ways to manage risk associated with derivatives trading:

• Limit position size to ensure a single trade does not dominate the portfolio. Allocating a small percentage of capital to each trade reduces exposure and protects against sudden market reversals.

• Tracking implied volatility. It helps in evaluating option premiums accurately. Elevated volatility may inflate option prices, creating potential overpayment risk.

• Options lose value with time decay. Managing option positions by considering theta ensures traders exit or adjust before rapid value erosion.

• Consider spreading contracts across multiple expiries to reduce concentration risk. This balances exposure between short-term volatility and long-term trends,

• Choose highly liquid contracts to minimise slippage and ensure efficient entry and exit.

Types Of Options Based On Underlying Assets

Now that you have understood ‘What is the difference between futures and options,’ let us learn about the types of options in detail.

Options are essentially versatile contracts with which you can trade various asset classes. The futures and options segment is built upon different assets (such as stocks, indices, currencies, commodities, etc.). Each of these are unique price drivers, here they are-

Stock options

A stock option is also called an equity option. It gives you the right to buy or sell a set of shares of a specific company's stock at a set price.

Index options

These contracts derive their value from a broad market index, such as the Nifty 50 or Smallcap Nifty 250, allowing you to trade the overall market direction.

Currency options

With currency options, you can trade the exchange rate between two currencies, such as the USD and the INR, at a fixed rate.

Futures options

The underlying asset for these contracts is a futures contract itself, giving you the right to enter a specific futures position.

Commodity options

Commodity options are linked to physical goods such as gold, silver, and crude oil. They provide a way to hedge against price swings.

Expiration Cycles In Options

Every option has a finite lifespan known as its expiration cycle. During this cycle, the trader has the right, not the obligation, to buy or sell the underlying security.

The options expiration cycle is the timeframe that determines how long you have to wait for your market prediction to come true before the contract becomes invalid.

Regular options

Usually, these are standard monthly contracts that expire on the last Thursday or Friday of the month, depending on the exchange.

Weekly options

These are designed for short-term traders. They expire every week and offer a faster way to profit from quick market news or events.

Quarterly options

These contracts expire at the end of each calendar quarter, bridging the gap between monthly and long-term investment strategies.

Long-term Equity Anticipation Securities (LEAPS)

LEAPS are long-dated options with expiration dates extending up to three years, allowing for long-term speculative or hedging positions.

Options Trading Strategies

Traders can choose a strategy depending on their outlook for the market's direction. There are four basic building blocks used by every beginner to manage risk and reward. Let us learn about them-

Long call

You buy a call option when you expect the price of the underlying asset to rise considerably before the expiration date.

Short call

You sell a call option if you believe the price to stay the same or drop, allowing you to keep the premium paid by the buyer.

Long put

Buying a put option is a bearish strategy used when you anticipate that the price of the asset will fall sharply.

Short put

You sell a put option when you expect the price to remain stable or increase, earning profit from the option's time decay.

Conclusion

Each contract plays a vital role in the share market. Futures require execution at expiry, a feature that options do not share. Options, however, allow flexibility by letting contracts expire worthless if conditions are unfavourable. Nonetheless, you can secure a contract in options by paying a premium. Depending on the price movement towards the conclusion of the following contract, the contract may be executed or allowed to expire without value.

Sources:

Moneycontrol