Difference between futures and options contracts

Difference between futures and options contracts

The option to buy the underlying asset is call option while the option to sell the asset is put option. In both the cases, the right of exercising the option lies with the buyer only, but he is not obligated to do so.

Understanding Forward Contracts vs. Futures Contracts

One of the key differences between options and futures is that options are exactly that, optional. The option contract itself may be bought and sold on the exchange but the buyer of the option is never obligated to exercise the option. The seller of an option, on the other hand, is obligated to complete the transaction if the buyer chooses to exercise at any time before the expiry date for the options.

Stocks and Futures - What is the difference?

Let s demonstrate with an example. Assume two traders agree to a $55 per bushel price on a corn futures contract. If the price of corn moves up to $55, the buyer of the contract makes $5 per barrel. The seller, on the other hand, loses out on a better deal.

While a commodity is a good that gets traded, a futures contract is a mechanism for carrying out such trades. Futures are agreements to buy or sell a quantity of something at a set price on a specific date in the future. That "something" can be commodities, shares of stock, bonds, currencies -- just about anything of value. Unlike an option, which merely gives the holder an opportunity to buy or sell something, a futures contract is an obligation. If you hold a futures contract to buy, say, 655,555 bushels of corn, you're on the hook to buy the corn -- unless you sell the contract to someone else.

Cometh the concept of a Forward Contract to help both the farmer and baker. The contract gave a benefit where they could transact at a certain fixed price at a future date then be affected by the vagaries of price movements in wheat. Let’s assume that wheat was at $65/bushel in the spot market.

However, when a seller opens a put option, that seller is exposed to the maximum liability of the stock’s underlying price. If a put option gives the buyer the right to sell the stock at $55 per share but the stock falls to $65, the person who initiated the contract must agree to purchase the stock for the value of the contract, or $55 per share.

Options are based on the value of an underlying security such as a stock. As noted above, an options contract gives an investor the opportunity, but not the obligation, to buy or sell the asset at a specific price while the contract is still in effect. Investors don t have to buy or sell the asset if they decide not to do so.  

The term 8766 financial derivative 8767 implies futures, forward, options, swaps or any other hybrid asset, that has no independent value, . its value is based on the underlying securities, commodities, currency etc. In this context, futures and options are often misconstrued, by many people. Futures may be understood as the legally binding contract to trade the underlying financial asset of standardized quality and quantity, at an agreed price, at a future specified date.

This is an amount to be put up with the exchange as you enter into the contract. This is similar to what we know as a ‘caution deposit’. Depending on the daily profit or loss arising in a position, the gain/loss is either added to or deducted from the initial margin on the day of entering the contract and from the remaining amount held in the margin account from the end of the day till contract expiration.

Options can be used to reserve the right to purchase or sell an item at a predetermined price during a set time period. For instance, a real estate investor might hold an option to purchase a piece of property during a time period while they determine if they can get the funding and permits they need. Such options, although not exchange-traded, give the buyer the “right of first refusal” when someone makes an offer on a property.

These are over the counter (OTC) contracts to buy/sell the underlying at a future date at a fixed price , both of which are determined at the time of contract initiation. OTC contracts in simple words do not trade at an established exchange. They are direct agreements between the parties to the contract. A clichéd yet simple example of a Forward Contract goes thus:

Because of the nature of these contracts, forwards are not readily available to retail investors. The market for forward contracts is often hard to predict. That s because the agreements and their details are generally kept between the buyer and seller, and are not made public. Because they are private agreements, there is a high counterparty risk. This means there may be a chance that one party will default.

These contracts are frequently used by speculators , who bet on the direction in which an asset s price will move, they are usually closed out prior to maturity and delivery usually never happens. In this case, a cash settlement usually takes place.

Basis for Comparison Futures Options Meaning Futures contract is a binding agreement, for buying and selling of a financial instrument at a predetermined price at a future specified date. Options are the contract in which the investor gets the right to buy or sell the financial instrument at a set price, on or before a certain date, however the investor is not obligated to do so. Obligation of buyer Yes, to execute the contract. No, there is no obligation. Execution of contract On the agreed date. Anytime before the expiry of the agreed date. Risk High Limited Advance payment No advance payment Paid in the form of premiums. Degree of profit/loss Unlimited Unlimited profit and limited loss.

Futures and Options both are exchange traded derivative contracts that are traded on stock exchanges like Bombay Stock Exchange (BSE) or National Stock Exchange (NSE) which are subject to daily settlement. The underlying asset covered by these contracts is the financial products such as commodities, currencies, bonds, stocks and so on. Moreover, both the contracts require a margin account.

Both options and futures contracts are standardized agreements that are traded on an exchange such as the NYSE or NASDAQ or the BSE or NSE. Options can be exercised at any time before they expire while a futures contract only allows the trading of the underlying asset on the date specified in the contract.

Futures were invented for institutional buyers. These dealers intend to actually take possession of crude oil barrels to sell to refiners or tons of corn to sell to supermarket distributors.

You can increase the leverage of trading stocks if you trade with a margin account. This usually allows you to purchase stocks on margin at the usual rate of 55%. So for every dollar you have you can purchase $7 worth of stock. The leverage is 7:6. How this works is that the broker is actually 'lending' you the other 55%. Of course by purchasing stock with margin you can lose more than you have due to the leverage. And in this case you can end up getting a 'margin call' from your broker if your stock losses too much value. But trading stocks comes no where close to the kind of leverage you get trading Futures.

When one party just bets on the underlying’s price movement to benefit from the forward contract without having actual exposure to the underlying. The farmer produces wheat and thus has an exposure to the underlying. What if some trader who has nothing to do with wheat, is betting on its price to fall and is thereby selling a Forward Contract just to make a profit?

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