Futures vs Options: Understanding the differences and choosing the right derivative instrument

Online trading applications have helped new-age investors and traders participate in Futures and Options trading as per their requirements.

Few novice investors and traders are curious and willing to explore this segment without understanding the risk involved in it.

This blog will try to explain the difference between the Future and Options segments that may help investors and traders to choose the right derivative instrument.

Before diving into the comparison, Let’s get a basic understanding of both the financial terms.

Futures are financial contracts obligating buyers to purchase or sellers to sell assets like equity, commodities, and currencies at a predetermined future date and price.Futures acts as a risk management tool; they allow investors to hedge against price fluctuations. Traders speculate on the future value of commodities, currencies, or equities, facilitating price discovery and market liquidity.These standardised agreements are traded on organised exchanges, providing a transparent platform for participants in the global financial markets.

Options are financial instruments that give the buyer the right, but not the obligation, to buy the call option of an underlying asset at a predetermined price within a specified timeframe.

This flexibility provides investors’ leverage in managing risk or capitalising on market movements.

Types of Option Contracts

Call options and put options. Both serve a different purpose and provide unique opportunities for traders and investors.

● Call Options: It gives the right, without any obligation, to purchase an asset at a predetermined price before or at the option’s expiration. Investors buy call options to capitalise on anticipated asset price increases. Call buyers pay a premium for this right, while call sellers are obligated to sell the asset if the buyer chooses to exercise the option, potentially profiting from the asset’s upward movement.

● Put Options: It gives the investor the right, without any obligation, to sell an asset at a predetermined price. Investors use put options to profit from anticipated asset price decreases. The Put buyer pays a premium for this right, while the Put seller is obliged to buy the asset if the option is exercised, creating opportunities for speculators and risk management strategies in financial markets.

Use of Option Strategies

Options trading involves predicting price fluctuations and offering a versatile approach for hedging, speculation, or income generation. It’s a tool to empower traders with diverse strategies to navigate financial markets.

The traders use many option strategies to manage their risk or even to generate returns. Commonly used strategies are straddles, strangles, bull put spread, bear call spread, iron condor, iron butterfly, etc.

These options and strategies give flexibility to traders to tackle market volatility and changes in the market environment.

Option strategies are very useful in dealing with the different phases of the market. In the past, we have seen that, at times, tradable instruments remain in a wide range. So, option strategies like Straddle and Strangle are used by traders to capitalise on such movements.

Futures vs Options – Key Differences?

Below is the table that provides a concise overview of the key differences between futures and options in the financial market.

Agencies

The choice between futures and options depends on your investment goals and risk tolerance – Both instruments can be used for hedging, but options offer more flexibility and limited risk.

Futures offer higher potential profits but also higher risk, while options provide limited profit potential with capped losses. However, Options require lower upfront capital compared to futures.

After studying Futures and Options, it can be said that both instruments have many differences and that they may be used by traders as per their requirements.

(The author is CEO of Bigul)