Futures vs Options: Key Differences Explained

Futures vs Options: Key Differences Explained

You’ve been following the stock market closely and heard about the buzz around futures and options trading. While both are popular investment tools, their mechanics can feel like a puzzle for beginners.

If you’ve ever wondered how these two derivatives work or differ, this guide will break it down for you. Understanding the nuances of options derivatives and futures is essential for smart trading strategies and this post simplifies the key differences to help you get started.

What Are Futures and Options?

Before diving into the differences, let’s first understand what futures and options mean in the trading world. Both are financial derivatives, meaning their value depends on an underlying asset such as stocks, commodities, or currencies.

Futures

Futures are contracts in which two parties agree to buy or sell an asset at a predetermined price on a specific future date. These contracts are binding and both parties are obligated to fulfill the terms regardless of market conditions at the time of expiry.

For example, if you enter into a futures contract to buy 100 company shares at ₹500 each, you must buy those shares at that price when the contract expires, even if the market price has risen to ₹600.

Options

Options give traders the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified period. There are two types of options:

●     Call Options: These give the right to buy the underlying asset.

●     Put Options: These give the right to sell the underlying asset.

For instance, if you purchase a call option for 100 shares at a strike price of ₹500, you can buy those shares at that price before the option expires, but you’re not required to do so.

Key Differences Between Futures and Options

Obligation vs Choice

The most significant difference lies in the obligation. Futures contracts require both parties to fulfill their agreement, while options derivatives offer flexibility. If the market moves unfavorably, an options trader can choose not to exercise the contract and limit losses to the premium paid.

Risk and Reward

Futures carry higher risk because traders must execute the contract, even if the market moves against them. This can result in unlimited losses. Conversely, options limit the maximum loss to the premium paid for the contract, making them relatively safer.

Upfront Cost

Futures typically require a margin deposit, a percentage of the contract’s total value, which can be substantial. Options, however, involve paying a premium, usually lower than the margin requirement for futures.

Use Cases

Futures are often used to hedge risks or speculate on price movements. They’re common in commodities trading and by institutional investors. Individual traders prefer options for hedging or leveraging positions due to their lower upfront costs and limited risk.

How Futures and Options Are Traded

Futures Trading

Futures are traded on exchanges like India's National Stock Exchange (NSE). The contracts are standardised, meaning the terms, such as quantity and expiry date, are predefined by the exchange. Traders need a margin account with their broker to participate in futures trading.

Options Trading

Options are also traded on exchanges but offer more flexibility. Traders can choose strike prices and expiry dates that suit their strategies. Like futures, options require a trading account and brokers often provide tools for analysis and execution.

Common Strategies in Futures and Options

Futures

1. Hedging: Businesses use futures to protect against price fluctuations. For example, a farmer might lock in a price for their crops to ensure stable income.

2. Speculation: Traders bet on price movements to earn profits. If they expect prices to rise, they buy futures contracts; if they expect prices to fall, they sell.

Options

1. Covered Call: This strategy involves holding a stock and selling a call option to earn premium income.

2. Protective Put: Investors buy put options to safeguard against potential losses in their stock holdings.

3. Straddle: Traders buy both call and put options to benefit from significant price movements in either direction.

Tools to Evaluate Futures and Options

Modern trading platforms and calculators simplify decision-making in derivatives trading. For options, tools like an SIP return calculator can help you project potential returns, particularly when integrating options into a broader investment strategy.

Though primarily for mutual funds, SIP calculators are excellent for gauging the long-term financial impacts of specific trading strategies.

Pros and Cons of Futures and Options

Futures

Pros:

●        High liquidity and standardised contracts.

●        Suitable for hedging large exposures.

●        Greater predictability in certain markets like commodities.

Cons:

●        Higher risk due to mandatory execution.

●        Requires significant capital for margin deposits.

Options

Pros:

●        Limited risk to the premium paid.

●        Flexible strategies for hedging and speculation.

●        Lower upfront costs compared to futures.

Cons:

●        Premiums can be expensive in volatile markets.

●        Complexity in selecting strike prices and expiry dates.

Which One Should You Choose?

The decision between futures and options derivatives depends on your investment goals, risk tolerance and market experience.

Futures are ideal for seasoned traders or businesses looking to hedge large exposures, while options are more suitable for individual investors or those new to derivatives trading.

For example, if you’re a cautious investor wanting to limit risks while exploring new markets, options might be better.

On the other hand, if you have significant capital and a high-risk appetite, futures can offer lucrative opportunities.