Investing in financial markets can be both thrilling and daunting, especially when you encounter terms like options and futures. These are two important types of financial contracts known as derivatives, meaning their value is based on the price of an underlying asset, such as a stock, commodity, or index.
Although both options and futures allow you to speculate on price movements in markets, they work very differently and come with distinct risks and benefits.
If you’re new to trading and investing, understanding the difference between these two financial instruments is crucial for making informed decisions.
In this guide, we’ll break down what options and futures are, how they work, and what sets them apart. By the end, you’ll have a better understanding of which might be more suitable for your investment goals.
What Are Options?
An option is a contract that gives an investor the right (but not the obligation) to buy or sell an underlying asset at a specific price, known as the strike price, before a set expiration date.
This means that with options, you are making a bet on the future price of an asset, but you don’t have to follow through with the transaction if it doesn’t work out in your favor.
There are two types of options:
- Call Option: A call option gives you the right to buy an underlying asset at a specific price before the option expires. You purchase a call option when you believe the asset’s price will rise.
- Put Option: A put option gives you the right to sell an underlying asset at a specific price before the option expires. You buy a put option when you believe the asset’s price will fall.
How Do Options Work?
When you buy an option, you pay a price called the premium. The premium is the cost of the option itself, and it’s typically a small fraction of the asset’s price.
The option’s value is largely influenced by the movement in the price of the underlying asset, as well as by other factors such as time decay and market volatility.
Call Option Example
Suppose you buy a call option for XYZ Industries limited with a strike price of ₹2,000 and a premium of ₹100. If the price of XYZ stock rises to ₹2,500 before the option expires, you have the right to buy it at ₹2,000 and immediately sell it for ₹2,500, making a profit of ₹500 per share (minus the premium of ₹100, so your profit would be ₹400 per share).
Put Option Example
Let’s say you buy a put option for XYZ Industries limited at a strike price of ₹2,000. If the stock price falls to ₹1,500, you can sell it at ₹2,000, thus making a profit of ₹500 per share (minus the cost of the premium). However, if the price doesn’t fall below ₹2,000, the option expires worthless, and you lose the premium you paid.
The risk with options is limited to the premium you pay. This makes options an attractive choice for traders who want to limit their potential loss.
American vs. European Style Options
There are two primary styles of options: American and European.
The difference between them is based on when they can be exercised (i.e., when you can buy or sell the underlying asset).
American Style Options
These options can be exercised at any time before and including the expiration date. This flexibility allows the option holder to act early if the market moves in their favor. American-style options are common in the U.S. market.
European Style Options
These can only be exercised on the expiration date itself. While this limits flexibility compared to American-style options, European-style options are often preferred for more structured, long-term investment strategies. These are common in Indian and European markets, though they can be traded globally.
Example:
- If you held an American-style call option on XYZ stock listed on the U.S. stock market, and the stock price increased significantly, you could exercise the option at any time before the expiration date to lock in your profit.
- In a similar scenario, if you had a European-style call option (listed on any stock market, such as the Indian stock market), you would have to wait until the expiration date to exercise the option, even if the stock price rose significantly before that time.
What Are Futures?
A futures contract is a more straightforward agreement. Unlike options, futures obligate both the buyer and the seller to complete the transaction at the specified price, regardless of whether the market price is favorable or not.
The buyer agrees to buy the underlying asset, and the seller agrees to sell it at the contract’s expiration.
With futures, you do not have the option to back out of the agreement like you do with options. This makes futures riskier because both parties are locked into the contract and must complete the transaction.
How Do Futures Work?
Let’s say you enter into a futures contract to buy 10 grams of gold at ₹50,000 per gram, with the contract expiring in three months.
At the time of the contract’s expiration, the price of gold might be different from the agreed-upon price.
- If the price of gold rises to ₹55,000 per gram by the time the contract expires, you can sell it at the higher market price, making a profit of ₹5,000 per gram.
- On the other hand, if the price falls to ₹45,000 per gram, you must still buy it at ₹50,000, incurring a loss of ₹5,000 per gram.
Unlike options, where your loss is limited to the premium paid, futures come with the potential for unlimited losses because both parties must fulfill the contract, regardless of how the market moves.
Key Differences Between Options and Futures
| Aspect | Options | Futures |
| Nature of the Contract | Grants the right, but not the obligation, to buy or sell | Obligates both buyer and seller to execute the transaction |
| Risk | Limited to the premium paid | Potentially unlimited losses |
| Obligation | No obligation to exercise | Both parties must settle the contract |
| Market Movement | Profit or loss depends on whether the option is exercised | Profit or loss is based on the final price at contract expiration |
| Expiration | Defined expiration date, but no obligation to execute | Defined expiration date, must be executed |
| Trading Strategy | Often used for hedging or speculation with limited risk | Often used for hedging or larger speculative positions with higher risk |
| Maximum Loss | Limited to the premium paid | Potentially unlimited loss if the market moves unfavorably |
| Market Participants | Popular among individual traders and speculators | Common among institutions, commodity producers, and speculators |
| Price Sensitivity | Affected by factors like time decay, strike price, and market price | Affected by daily price fluctuations, marked-to-market daily |
Types of Futures Contracts
Futures contracts are diverse and can be based on many types of assets.
Some examples include:
- Commodity Futures: These involve products like gold, wheat, and crude oil. Investors can use these contracts to speculate on commodity prices or hedge their exposure to price changes in raw materials.
- Stock Index Futures: These are linked to the performance of stock indices, such as the Nifty 50 or Sensex. Investors use them to speculate on the overall direction of the Indian stock market.
- Currency Futures: These contracts allow investors to speculate on future exchange rates between different currencies, like the Indian Rupee (INR) and the US Dollar (USD).
How Are Options and Futures Traded in India?
In India, both options and futures are traded on exchanges like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). These exchanges provide a platform for individual investors, institutions, and professional traders to buy and sell contracts.
Options Trading in India
Options in India are most commonly traded on stocks, stock indices (like the Nifty 50), and even currency pairs. Options are particularly popular among retail traders looking to profit from short-term price movements.
Futures Trading in India
Futures are widely traded on commodities like gold and crude oil, as well as stock indices like the Sensex or Nifty 50. Institutions and commodity producers use futures to hedge against price fluctuations, while speculators use them to bet on the direction of prices.
Who Trades Options and Futures?
Both options and futures are popular with institutional investors like banks, hedge funds, and commodity producers. These groups often use these contracts to hedge against risks. However, they are also available to retail investors through online brokerage accounts.
Understanding how options and futures work is essential for anyone looking to trade in financial markets. Whether you are looking to hedge your investments or engage in speculative trading, these financial instruments offer a range of strategies and risks that can fit different investment objectives.
Key Takeaways
- Options give the investor the right, but not the obligation, to buy or sell an asset at a specific price before the expiration date. The risk is limited to the premium paid.
- Futures contracts obligate both the buyer and seller to complete the transaction at the expiration date. They come with the potential for higher risk and larger rewards.
- Options are more suited for traders who want to limit risk and engage in speculative strategies. Futures are more commonly used for hedging or larger speculative positions, with the potential for both higher profits and losses.
