The key difference between Futures and Options..!!
An investor who has a little bit higher risk appetite chooses derivatives. The fundamental principle behind the choice of derivative product is the higher the risk, higher the reward will be. In that scenario, the future and options have become quite popular derivatives among investors. This is mainly due to advantages, they offer in terms of risk and reward ratio, leverage and high liquidity. Future and options are two individually different products, but belong to the derivative segment, whose value derives from the value of an underlying asset. The underlying asset can be anything such as stocks, indices, currency, gold, silver, wheat, cotton, and petroleum etc. Future and options are basically used for two different purposes. One is used for the hedging and another is used for speculations. Stock market prices can be volatile in a certain environment. In order to protect the losses producers, traders and investors buy such derivatives which can come in handy to hedge against such volatility. If they make a right predication about price movement accurately, they can make money through such derivatives.
Future is basically a contract that the holder has the right to buy or sell a certain asset at a specific price on a specified future date. Whereas options give the right, but not the obligation to buy or sell a certain asset at a specific price on a specified date. They both are available in lot size. The particular stock exchange determines the size of the lots, which differ from share to share. Let’s look at the major difference between future and options:
- Binding to the Contract: The future contract is binding on the parties. Once the futures contract is done, it should be binding on the parties. The contracthas tobe honoured at that particular date and the buyer is locked into the contract. But the option doesn’t carry any such obligation.
- Level of Risk: Risk associated with future is quite high. While the level of risk associated with the option is restricted only to the premium paid.
- Payment in Advance: In future contracts, there is no advance payment to be paid. But in the case of options, a small percentage of the entire amount is paid in advance.
- Limit to Profit and Loss: In future contracts, there are no limit amounts of profit/losses to the counterparties, whereas options contract has unlimited profits with a cap on the number of losses.
- Execution of a contract: In the case of future contracts, the execution of the contract can only be done on the pre-decided date which is mentioned in the contract. While in the case of option contracts, performance plays an important role. They can be done at any time prior to the date of expiry.
To get a better understanding, whether the future and options are best. Let’s take an example, suppose that an investor wants to buy 1000 shares of Honda at a price of Rs 300. To purchase the total stocks, investors need an investment of Rs 3 lakhs. But he/she can also buy a lot size (let’s say consist of 1000 shares) of Tata Motors. The advantage is that, when an investor buys the future, he/she can only pay the margin which is around lest say 20% of the full value. It means that the profits will be fivefold that of when you are invested in equities, but the losses will be in the same proportion.
Now Imagine an investor buy the same contract option at a price of Rs 10. Since the lot size is 1000 shares, then the maximum loss will be Rs 10000 only. But on the downside, if the Honda prices reach to 200, the loss will be Rs 10,000 but in case if it goes above 310, the profit will be unlimited.
*Disclaimer: investment in securities market are subject to market risks, read all the related documents carefully before investing