Futures vs options

Futures vs options

Knowing whether to trade futures or options in the stock market is a critical decision that every commodity trader makes. Established commodity traders in the Indian stock market have also known to fluctuate back and forth on choosing the better method for trading.

Depending on the situation, futures and options can be used; both have their pros and cons. Hence, it is essential to understand the features of each when you are trading in commodities. Once you know their characteristics, from there, it can be a matter of using the right strategy to take the most benefit from it.

What are futures and options?

  • Futures: Is a right and obligation to purchase or sell an asset at a predetermined value and deliverable at an arranged time.
  • Options: Is a right without the obligation to purchase or sell equity or index.

Vital Futures and Options Terms

There are specific terms used in both futures and options that you must know when trading in the stock market. In options, ‘put and call’ are critical to the business.

  • Put is the ability to sell a financial instrument at a predetermined price.
  • Call is the ability to buy a financial asset and a fixed price.

In short, a put option is a right to sell while a call option is the right to buy.

In addition, ‘expiration date’ is also crucial. It is the date by which the option must be put into action; else it becomes null and void.

In futures, ‘exercise price’ or ‘futures price’ is the price of the financial asset that must be paid in the future. The trader setting the futures contract is called ‘short’.

Let’s understand futures with an example.

Say you are looking to purchase 1500 shares of Company A at the cost of Rs. 400 per share. This would require an investment of Rs. 6 lakhs to buy the said quantity. Alternately, you can purchase a lot of 1500 shares of Company A. The benefit in doing so is that when you buy futures, you only pay the margin, say, for instance, 20% of the entire value. This means that your profits are likely to be fivefold when invested in equities. However, on the flip side, the losses can be fivefold as a risk of leveraged trades.

Let’s understand options with an example

As stated above, an option is a right without an obligation. Hence, you can purchase Company A’s 400 call option at a price of Rs. 10. Since the lot size is 1500 shares, you could face a maximum loss of Rs. 15,000. However, on the flip side, if Company A declines to Rs. 300 a share, your loss could go to Rs. 15,000. But the benefit here is that over Rs. 410 your profits could keep rising.

Below is a comparison chart between futures versus options:

  FUTURES OPTIONS
MEANING A binding arrangement, to buy and sell a financial asset at a fixed price on a specified date. A contract wherein an investor obtains the right to buy or sell a financial asset at a fixed cost, on or before a specified date, without any obligation.
BUYER’S OBLIGATION To execute the contract No obligation
EXECUTION OF CONTRACT On the specified date At any time, before the date’s expiry
RISKS High Limited
PAYMENT TO BE MADE No payment Paid as premiums
PROFIT OR LOSS Unlimited degree of both profit or loss Unlimited profit, restricted loss

 

Similarities

Futures and options are traded on stock exchanges such as the Bombay Stock Exchange and the National Stock Exchange. As exchange-traded derivatives, both futures and options are subject to daily settlement. Both these contracts cover underlying assets and financial products such as stocks, bonds, currencies, commodities and more. Futures and options both require a margin account.

Bottom line

If you are considering trading in commodities, you may want to tip up with a well-known and full-service broker such as Kotak Securities. To trade in the stock market, it is essential to have a Demat and trading account, but the decision to know whether you are looking to trade in futures or options is dependent on your risk appetite, financial goals, time horizon and your perception on the direction of the market price and price volatility.

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