In the world of financial trading, two commonly used instruments are futures contracts and futures options. These are types of derivative contracts, which means their value is derived from an underlying asset such as a stock, commodity, currency, or index. While both tools serve the purpose of managing risk or speculating on price movements, they function in significantly different ways.
Understanding the difference between futures and options is vital for investors and traders looking to make informed decisions in the derivatives market.
What Are Futures and Options?
Meaning of Futures
A futures contract is a legally binding deal between two parties to purchase or sell a specific asset at a set price on a predetermined future date. Upon expiry, both the buyer and seller are required to honour the terms of the agreement. These contracts are standardised and traded on established exchanges like the NSE or BSE in India.
Futures are commonly traded across various markets, including commodities, currencies, and equities. Their primary role is to lock in prices to protect against adverse market movements, making them popular for hedging purposes.
Options Meaning
Options contracts, unlike futures, provide the buyer with the right but not the obligation to buy or sell an asset at a specified price before a certain expiry date. There are two types of options: call options (which allow buying the asset) and put options (which allow selling it).
Options are also traded on major exchanges and are typically used for limiting potential losses while maintaining profit potential.
Key Differences Between Futures and Options
| Feature | Futures | Options |
| Definition | Legally binding agreement to buy or sell an asset at a fixed price on a future date. | Contract granting the right, but not the obligation, to buy/sell an asset. |
| Obligation | Both parties are required to carry out the terms of the contract when it reaches its expiry date. | Buyer has no obligation; seller may have to honour if the buyer exercises the option. |
| Risk | High risk due to full exposure to market fluctuations. | Buyers face limited risk, restricted to the premium paid, while sellers may be exposed to greater potential losses. |
| Profit/Loss Potential | Both profits and losses can be unlimited. | Buyers have the chance to earn unlimited profits, while their losses are confined to the premium amount paid. |
| Upfront Cost | No upfront payment other than margin requirements. | Buyer pays a non-refundable premium to the seller. |
| Execution | Automatically executed on the expiry date. | The buyer has the right to exercise the option at or before expiry (depending on the option type). It is not automatically executed unless chosen by the buyer or, for some contracts, automatically exercised if in-the-money at expiry. |
| Flexibility | Less flexible; trade must be completed. | Offers greater flexibility, as buyers can choose not to exercise the option and let it expire if market conditions are unfavourable. |
| Use Case | Preferred for hedging or speculation with high certainty of trade. | Suitable for cautious investment approaches or during periods of market uncertainty. |
| Margin Requirement | Requires a margin account and daily mark-to-market settlements. | Sellers require margin; buyers only pay the premium. |
| Liquidity | Generally more liquid in commodity and index markets. | May have lower liquidity than futures in some markets. |
| Value Decay | No time decay effect. | Suffers from time decay; value decreases as expiry nears. |
Real-World Example
Imagine you anticipate that crude oil prices will increase over the next three months. If you choose to enter into a futures contract, you’re obligated to purchase crude oil at a predetermined price when the contract expires. Should the market price fall instead of rising, you could face significant losses due to the binding nature of the agreement.
On the other hand, if you decide to buy a call option on crude oil futures, you gain the right—without the obligation—to purchase at the agreed price. If prices rise as expected, you can exercise the option and profit from the difference. If the market moves against you, you can simply allow the option to expire, with your maximum loss limited to the premium you initially paid.
Options vs Futures Based on Value Movement
The value of futures contracts moves directly in line with the underlying asset. If the price of the asset increases, the value of the futures contract also increases proportionally.
On the other hand, futures options are influenced by multiple factors including:
- The price of the underlying futures contract
- Time remaining to expiry
- Volatility of the market
- Interest rates
As options near expiration, their value often declines due to time decay. This is a critical aspect to consider when trading options.
Capital Requirements
Futures contracts generally require a higher capital investment since you must maintain a margin account and handle daily mark-to-market settlements. Conversely, options contracts require lower capital upfront. Buyers only pay a one-time premium.
However, the premium is non-refundable, and if the market moves unfavourably, that becomes your maximum loss. This makes options particularly attractive for retail investors or traders who want to manage risk without significant capital exposure.
Liquidity Comparison
Futures contracts tend to be more liquid than options, especially in major commodity and index markets. The consistent structure and direct exposure make them a popular choice for active day traders. Options contracts, while offering more versatility, may suffer from lower liquidity—especially when trading contracts that are far out-of-the-money or have long expiry dates.
Types of Options Based on Underlying Assets
- Stock options: Underlying asset is a company’s shares.
- Index options: These are linked to the performance of market indices such as the Nifty or Sensex.
- Currency options: Allow trading based on currency exchange rate movements.
- Futures options: These are options where the underlying asset is a futures contract.
- Commodity options: The underlying asset is a physical commodity or commodity futures.
Expiration Cycles in Options
- Regular options: These have standard monthly expiry cycles.
- Weekly options: Expire every week, suited for short-term strategies.
- Quarterly options: Expire every three months, offering medium-term flexibility.
- LEAPS (Long-term Equity Anticipation Securities): These options can have expiration dates extending up to three years.
Options Trading Strategies
- Long call: Buying a call option to benefit from a rise in the asset price.
- Short call: Selling a call option expecting the price to stay stable or decline.
- Long put: Buying a put option to profit from a drop in price.
- Short put: Selling a put when you expect the price to stay the same or rise.
Each strategy has its own risk-return profile, and understanding them helps traders manage their positions more effectively.
Conclusion
Both futures contracts and futures options play an integral role in modern financial markets. The primary difference between futures and options lies in the obligation and risk associated with each.
If you’re looking for a high-risk, high-reward strategy and are comfortable with significant exposure, futures may suit your approach. However, if you prefer flexibility and limited losses, options could be the better choice. Understanding the differences of options and futures will help you choose the instrument that aligns best with your financial goals and risk appetite.
FAQs
Which is cheaper futures or options?
Futures contracts usually cost less than options because they involve lower volatility and only require a margin payment, typically between 3% and 12% of the trade value. In contrast, options require an upfront premium based on the asset’s current price and market outlook.
Which Is Safer: Futures or Options?
Both futures and options involve risk, but the level of risk differs. Options are generally considered safer for individual investors because losses are limited to the premium paid. However, they can lose value quickly due to time decay (theta). Futures, on the other hand, carry higher risk since both parties are obligated to fulfil the contract, and losses can be significant if the market moves unfavourably.
Which has more leverage options or futures?
Futures are fungible contracts. And one advantage of trading futures vs. options is that futures allow you to use more leverage. Additionally, a futures market is more liquid, which helps with relatively low spreads.
Are futures riskier than options?
Trading futures and options both involve risk. Options contracts lose their value fast because of high theta decay and, if not exercised on time, may result in a 100 percent loss. But futures are risker for individual investors. An essential difference between futures and options is managing the margin value. Based on the underlying stock price movement, either party might have to add more money to the trading account to maintain daily trading obligations, which increases the total cost of futures for small investors.
