What is Futures and Options? Meaning, Types, and Differences
07 November 2024
12 min read
00:00 / 00:00
Futures and options are essential tools used for hedging and speculation in the financial markets. But what exactly are they, and how do they work? In this article, we'll understand the basics of futures and options trading, their types, and differences with proper examples. Understanding these powerful trading instruments and their applications can help you navigate the world of derivatives. So, let’s get started!
What are Derivatives Contracts?
Derivative contracts are a type of financial instrument that derives its value from an underlying asset which can be stocks, bonds, commodities, or currencies. These contracts are agreements made between two or more parties that are to be executed within a predetermined date and time. Participants use these contracts to Hedge, Speculate, or as a method of arbitraging the market
These derivative contracts are mainly categorized into 4 types: Forwards, Futures, Options, and Swaps. Among these, futures and options are the most widely used instruments in derivative trading.
What are Futures and Options in the Stock Market?
Futures Contract:
Futures are a type of derivate contract whose value is based on an underlying asset. These contracts are entered between two parties to buy or sell a particular asset on or before a particular date at a predetermined price. Here, the two parties must compulsorily execute the contracts irrespective of whether they incurring a profit or a loss
For example, If a wheat farmer is getting his wheat ready to sell in 3 months. Currently Wheat is available for Rs.40 per Kg. In three months, this price might go up or come down. To avoid the risk of loss, the farmer can choose a future contract for Rs.40 per Kg for which he must sell wheat on a future date.
After 3 months, If the price comes down to Rs.30, the farmer avoids the loss of Rs.10 as he made a future contract for Rs.40 and he will sell his wheat at the price quoted in the contract. In this case, the buyer will have to bear a loss of Rs.10
Similarly, If the price goes up to Rs.50 per Kg, the farmer will lose the chance of gaining Rs.10 profit since he is obliged to sell his wheat at the quoted price. In this case, the buyer gains Rs.10 profit.
Options Contract:
Similar to futures, an options contract also derives value from an underlying asset and is an agreement entered between 2 parties (Options writers/sellers and Option buyers) which is to be executed at a predetermined price on a future date. In the options market, option writers create options contracts, while option buyers purchase these contracts to buy or sell an underlying asset.
Here, the buyers of the options contract have the right but not the obligation to buy or sell the underlying asset on a future date. For this right, the option buyer will have to pay a fixed amount called the premium to the option seller. On the other hand, the seller will have to compulsorily execute the options contract on the demand of the buyer of the option, irrespective of them incurring a profit or a loss.
These options contracts can further be classified into the following:
Call Option: These contracts are bought when an options buyer expects the price of an underlying asset to increase. Conversely, call options are sold by the option writers when they think the price of the underlying asset will decline.
Put Option: These contracts are bought when the buyer of an option expects the price of an underlying asset to decrease. Conversely, put options are sold by the option writers when they think the price of the underlying asset will increase.
Types of Futures and Options
Based on the type of underlying asset the contracts derive their value from, futures and options contracts can be categorised into the following:
1) Equity Futures & Options
2) Currency Futures & Options
3) Commodity Futures & Options
Difference Between Futures and Options
There are several differences between futures vs options, including contract obligations, risk-to-reward ratios, and more, as discussed below:
1) Contract Obligation:
In a Futures contract, both the buyers and sellers of the options contracts are obligated to execute the contracts at the predetermined price regardless of them incurring a profit or loss.
In the case of option contracts, the buyer of the option contract has a right but not an obligation to execute the contract. On the other hand, the option seller is obligated to fulfill the option contract if the options buyer executes the contract
2) Risk to Reward:
Both the buyer and seller of the option contracts have the potential to earn unlimited profits and at the same time, can also incur unlimited losses.
In the case of options contracts, the buyers have the potential to earn unlimited profits while the exposure to losses is only limited to the premium paid by them to the sellers.
3) Upfront payment:
You do not need to pay an upfront margin while trading in the futures contract. However, you are required to deposit a margin which acts as collateral to cover potential losses.
Option buyers are only required to pay the premiums for the strike price and do not need any collateral. On the other hand, options sellers need to have margins as collateral in case the options buyers execute the contract.
4) Probability of Profit:
In futures contracts, your probability of profit will depend on the movement of the underlying asset. This means you will start earning profits when the underlying asset starts moving in your direction.
For options contracts, the probability of profits will also depend on options Greek apart from the movement in the underlying asset. Among the Greeks, time decay(theta) is the main factor that determines the value of option premiums.
Here the theta erodes the value of the option premium as it moves closer to the expiry. Thus, the probability of profit for option buyers will depend on the likelihood of the underlying asset price reaching the strike price within the expiry. Therefore, the options sellers have a better chance of profitability compared to the options buyers.
5) Liquidity:
While positions in futures contracts are highly liquid, the liquidity in the options contract will depend on the strike prices of an underlying asset. For instance, strike prices that are in-the-money and at-the-money offer higher liquidity compared to strike prices that are far out-of-money.
Similarities Between Futures and Options
1) Derive their value from an underlying asset.
Both futures and options are derivative contracts whose value is derived from underlying assets such as stocks, commodities, and indices. These contracts allow investors to speculate on the prices of investments without actually owning them.
2) Involves Two Parties
These contracts are entered between two parties, that is, the buyer and seller which are to execute at a predetermined price on a future date.
3) Give you Leverage
With Futures and option contracts participants can buy or sell larger values of the underlying asset with a lesser capital. Thus, increasing the potential of earning profits.
4) Expiration Date
Both futures and options contracts have a set date on or before which the contracts have to be executed. However, in the case of option contracts the buyers have the option of not executing the contracts
5) Purpose of the contracts
Future and option contracts are both used by different types of market participants including speculators, hedgers, and arbitrageurs. Speculators seek to profit from price changes, hedgers protect against adverse price movements with these instruments and Arbitrageurs exploit price differences between markets.
Advantages of Futures Trading
Leverage: Futures contracts allow participants to buy or sell larger quantities of the underlying asset with less capital, thereby increasing the profit potential.
Hedging: It can be used by the market participants as a means to protect themselves from the fluctuations in the market.
Liquidity: The future markets are usually very liquid; hence, one can buy and sell contracts in no time and with minimal effort.
Unlimited Profit: Both the parties involved in the futures contract have the potential to earn unlimited profits as long as the underlying asset is moving in their direction.
Rollover Option: If the participants wish to continue to hold the position even after the expiry, they can shift their expiry to the next expiry (rolling over contracts) by paying the difference in the contract amount. Participants can keep rolling over the contracts until they reach their desired outcome.
Risks in Futures Trading
High Margins: While the futures contracts do provide leverage, the margins required to enter are still high. Furthermore, any significant price movements can trigger a margin call, requiring participants to deposit additional capital.
Unlimited Losses: Similar to earning unlimited profits, participants can also incur unlimited losses if the underlying asset moves against their direction.
Obligation to Settle: Both parties are obligated to execute the futures contract at expiration, which can result in losses to one of the parties if the market moves against their position. However, they have the option of rolling over the contracts by paying the difference in the strike price.
Advantages of Options Trading
For Options Buyer
Leverage: The margins facility required for Option buyers are significantly lower than what you would require in futures contracts.
Limited Risk: The maximum loss for the option buyers is limited to the premium paid by them.
Unlimited Profit: From only paying the premium amount, the option buyers have the potential to earn unlimited profits.
Flexibility: Option buyers have the right to decide whether to execute the options contract.
For Options Seller
Higher Chances of Profit: Time decay works in favor of the option sellers and as the contracts get closer to expiry, they decrease in value. Thus, option sellers have higher chances of profit because most of the options contracts expire out-of-money.
Profit in different market conditions: While option buyers need the underlying asset to move in their favor to earn profits, option sellers can earn profits when the underlying asset is either sideways or is moving against the direction of the option buyers.
For Both
Variety of Strategies: Options traders can employ different option strategies by buying or selling different types of options. These strategies can be used to cater to different market conditions and they can also help in reducing the overall margins required to trade in options.
Risks in Options Trading
For Options Buyer
Time Decay: As the options contracts near their expiration date, their time value from premiums keeps on decreasing. This makes it difficult for the buyers to earn profits.
Low Chances of Profit: In a neutral or less volatile market, the chances of option buyers earning profits are significantly lower than those of an option seller. This is mainly because the theta erodes the value of the premium as it closes to expiry.
For Options Seller
High Margins: While the option sellers receive an upfront premium from the buyers, they are required to maintain a large margin in case the underlying asset moves sharply against them.
Unlimited losses: While the chances of profitability are more in options selling, the sellers have the chance to incur unlimited losses if the underlying asset moves against their favor.
High Volatility(Vega): When volatility increases in the market, the value of options premiums increase, and also the chances of the underlying asset moving in the buyer's favor increases
Limited Profits: As options selling is a net credit strategy, you will receive an upfront premium from the option buyers. This will be the maximum profit the options seller can earn no matter how the underlying asset will move in their favor.
For Both
Complexity: Options contracts are far more complex than futures contracts. They involve many terms, and strategies and their pricing is dependent on the factors known as the ‘Greeks’ making them less suitable for beginner traders.
Which is Better: Futures or Options?
When comparing futures and options, we are essentially comparing futures contracts, buying options, and selling options. The better choice among these depends on your personal preferences and risk tolerance. Here’s a breakdown of the three options:
Futures: This is suitable for those who have a large capital and do not want to deal with the complexities of options Greeks. Here, both parties have an equal probability of success and the prices of the futures contracts are mainly dependent on the movement of the underlying asset.
Buying Options: This is suitable for those who want to deal with limited risk and also want to earn unlimited profits. However, option buyers have time decay working against their favor which greatly decreases the probability of success.
Selling Options: This is suitable for people who have a large capital and want a greater probability of profits. However, option sellers do bear the risk of unlimited losses and need to have good risk management skills to manage their losses during volatile markets.
Is F&O Trading Profitable?
F&O trading is profitable, but it is accompanied by a lot of risk. It demands skill, discipline, and good knowledge of markets. Furthermore, it should be noted that the profitability in F&O trading depends on market knowledge, strategy, timing, and risk management.
How to Trade in Futures and Options
Follow these simple steps to get started with Futures and Options trading:
Download Rupeezy App: To start investing in the stock market, you need to install Rupeezy’s Flow app from the Google Play Store or App Store.
Visit Website: You will be redirected to Rupeezy's official website to begin the account creation procedure.
Fill in Personal Details: Fill out your personal information, including your name, address, PAN number, and contact information.
Upload Documents: Upload the required documents for KYC verification, such as an Aadhar card, a PAN card, and bank statements.
eSign the Form: Finish the process by electronically signing the application form.
Verification: Your information will be verified by Rupeezy’s onboarding staff, and once verified, your Demat account will be activated. You will receive an email including your login credentials, such as the Client Code, and other details.
Set the Password: Secure your data and activity by creating a password in the application.
Start Trading: Once your account is active, you can start trading with futures and options using the broker's platform.
Search for Futures and options: In the watchlist, you can find futures & options and other derivatives such as commodities, and start trading in it.
Conclusion
Wrapping it up, Futures and options (F&O) are versatile tools for hedging and speculation, each with unique benefits and risks. Futures offer high leverage and liquidity, while options provide flexibility and limited risk for buyers. However, it should be noted that profitability in F&O trading depends on market knowledge, strategy, timing, and risk management
