Futures vs Options – What is the Difference?

---

One thing that is guaranteed in the stock market is uncertainty. Prices can go up or they go down or even not move at all depending on the market conditions like economic factors, elections, weather, agricultural produce and output. Since there are so many fluctuations that can take place, traders look to protect themselves from such fluctuations and resort to an instrument called derivatives. A derivative is a contract that derives its value from the underlying asset which could be anything like a stock, commodity or currency or so on. And the two most common derivatives are Futures and Options.

Futures and Options are probably the most widely traded derivative instruments across the world. But then, despite having their own inherent advantages, they differ in a few ways. But before we get into the differences between them, it’s important to know what each of them means.

Futures – What are they?

A futures contract is an agreement between two parties, where one party agrees to by an underlying instrument, be it stock, currency, index or a commodity at an agreed price on a future date from another party. The agreement is completed on a future date, either by actual delivery of goods or by cash settlement of the difference between the current market price on the future date and the agreed price. In general, the futures market is used as an effective hedge tool to lock your price, however, in practice, there are several people who speculate through futures market as well. 

Let’s explain this with an example. Let’s say you bought a futures contract of 1000 shares of Nestle at Rs. 100 each at a specific date. On the expiry of the contract, you will get those shares at the agreed price irrespective of the current market price. If the market price is Rs. 110 then you will still get it at Rs. 100 and in the process make a profit of Rs. 10,000. But if the market price of the share is Rs. 90 then you will still get it at Rs. 100 but make a loss of Rs. 10,000.

The whole idea of futures is to help in evading the price fluctuations of the market and is an effective tool used by traders to protect their portfolios.

What are options?

Options are a type of derivative contract wherein the buyer or seller has the right, but not the obligation to buy or sell a particular asset at a specified price and date.

For example, suppose Rahul bought a ticket to a screening of Dilwale Dulhania Le Jaayenge that is due to happen on a future date. Having bought the ticket, he has officially got the right to view and attend the concert but are under no obligation to do so. In fact, he can either attend the movie, sell the ticket for a higher price or do neither and let it go waste. But the seller who sold the ticket has the obligation to play the movie irrespective of whether Rahul exercises it or not. This is how options work in the stock market. 

Options are of two types

• Call Option – A call option is a contract that gives the buyer the right but not the obligation to buy a particular asset at a specified price and date. 
• Put Option – A put option is a contract that gives the buyer the right but not the obligation to sell a particular asset at a specified price and date. 

How do Futures and Options differ from each other?

While both instruments are similar in hedging the portfolio from market volatility and price fluctuations, they are different on several factors. They are

• Nature of the contract

A futures contract is a derivative instrument within which an agreement is entered into between a buyer and a seller where the buyer agrees to purchase the underlying at a specified time in the future for a fixed price. Thus, on the agreed expiry date, both parties are expected to fulfil their obligations and honour the contract. The buyer is expected to buy at the agreed price and the seller, to sell.

An options contract, on the other hand, gives the buyer the right to buy the asset at a fixed price. However, there is no obligation on the part of the buyer to buy- they have a right to exercise their option only if the conditions turn favourable. Nevertheless, should the buyer choose to buy the asset, the seller is obliged to sell it. 

Thus, the first point of difference is that an options contract gives a right to the holder while there is no such privilege in a futures contract. 

• The risk involved

As we saw earlier, both parties of the futures contract are expected to honour the contract even if the market moves against them. 

On the flip side, the buyer in an options contract has a privilege here. If the underlying moves in a direction unfavourable to them, the buyer can opt-out of buying it. This limits the loss incurred by the buyer.

In simple terms, a futures contract could bring unlimited profit or loss. Meanwhile, buying an options contract can bring unlimited profit, but it reduces the potential loss.

• Concept of Premium

The holder in an options contract has to pay an upfront payment of what is known as a premium. The payment of this premium grants the options buyer the privilege to lapse or exercise his right depending upon the movement of the underlying either unfavourably or favourably. Should the options contract holder choose not to buy the asset, the premium paid is the amount he stands to lose. This right to exercise or lapse ensures that the maximum loss that the holder can suffer is restricted to the premium paid. The writer though has unlimited loss potential. 

On the contrary, since the futures market grants no such special rights, there is no requirement for any premium payments in the futures segment. A futures trader has on the other hand put up a margin for initiating a position. 

• The Concept of Margin and Profit and Loss

Considering the risk of potentially unlimited loss, the Exchange warrants both the buyer and a seller in a futures market to deposit what is known as a margin. The margin requirement varies based on the scrip traded in and acts as a safeguard for the exchange to mitigate any counterparty risk of default. 

The profits or losses on a futures trade are calculated and marked to market on a live market and adjusted in their margin account. Any fall in the margin levels due to losses might lead to the issue of a margin call. A margin call is when the broker asks the trader to either add more margin in his account or square off the position. Any gains on the trade are credited to the margin account. 

Typically, in the Options market too, the profit or loss is calculated on a real-time basis and reflected in your position. Unlike a futures contract, an option buyer doesn’t have any margin that he needs to maintain if he is a buyer. This is because margin money is a typical requirement by the exchange to protect against the risk of default. 

If I want to buy a TCS option for Rs.9,000 strike at Rs.100 premium for a lot size of 150 shares, I can buy it if I have Rs.15,000 in my account. Now, as a call option holder, we know that the maximum loss I can suffer is Rs.15,000 which happens to be my premium. Therefore, there is no risk of default or loss since I am paying the premium upfront. Thus, an option holder needs to hold no margin. However, in the case of an option seller, the risk of loss is unlimited and hence they are required to maintain a margin with the exchange. This margin too changes based on the scrips, strike prices, expiry and so on. 

The profit on a call option is calculated as follows. 

P&L = [Difference between buying and selling price of premium] * Lot size * Number of lots

If you buy a TCS Call options with January expiry on 5th January for a lot size of 150 shares at Rs.80 and sell it on January 15th at Rs. 95, then the profit on your trade is (95-80) *150*1= Rs.2,250.

In practice, there could be brokerage and other charges deducted from your profits.

For a seller too, the profits are similar:

The profit on their transaction is:

[Difference between the buy price and sell price of premium] * lot size * number of lots

In case the options are held to expiry, as per SEBI guidelines, physical delivery of the share could be warranted. 

Conclusion

Futures and Options are a way for traders to protect themself from the constant price fluctuations in the market. Often this kind of trading is seen in the commodity market as well where people trade in futures and options for commodities like crude oil, gold, wheat, maize etc. while trading in this segment gives quick profits over a short period of time, it is imperative that those who trade in such segments are experienced with knowledge of the market as profits are there but the losses are unlimited.