Difference between Futures and Options

Key difference: Both, futures and options are types of derivatives. Essentially, futures allow a person to buy or sell an asset at a specified price on or before a specific date in the future. This allows the person to hedge or to speculate on the price movement of the asset. Options, on the other hand, are contracts that give the owner the right, but not the obligation, to buy or sell an asset. Hence, one can buy the right to buy or sell an asset at a specified price before the specified period ends. However, if the person does not feel that the asset is worth buying during that time, he may forgo the contract.

Both, futures and options are types of derivatives. A derivative is a financial instrument that does not have a fixed value. Its value is derived on the basis of market securities, indices, and/or underlying assets, such as commodities, stocks, bonds, interest rates, and currencies. In practice, a derivative is a contract between two parties. It specifies the conditions under which two parties have to exchange payments, including but not limited to “the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount.”

Investopedia defines futures as “a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.”

Essentially, futures allow a person to buy or sell an asset at a specified price on or before a specific date in the future. This allows the person to hedge or to speculate on the price movement of the asset. Hence, the person can buy at a price specified now, in hopes that the specified price will be less than the price on the specified date.

The futures contracts will specify the quality and quantity of the asset to be bought or sold. The contracts are standardized contracts written by a clearing house. The futures contract trade on a futures exchange. Some contracts may call for physical delivery of the asset, while others are settled in cash. 

Options, on the other hand, are contracts that give the owner the right, but not the obligation, to buy or sell an asset. Hence, one can buy the right to buy or sell an asset at a specified price before the specified period ends. However, if the person does not feel that the asset is worth buying during that time, he may forgo the contract.

Investopedia defines options as “a financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date). “

There are two main types of options contracts: call options and put options. Call options allow the person to buy a certain quantity of the asset at a specified price on or before a given date in the future. Put options allow the person to the right to sell a certain quantity of the asset at a specified price on or before a given date in the future.

The price specified in the options contract is called the strike price. This is the price that the person will buy or sell the asset at. The date at which the contract expires, or the date at which the person is last able to buy or sell is called a maturity date. In the case of a European option, the sale can take place on but not before the maturity date. In the case of an American option, the sale can take place at any time up to the maturity date.

The main difference between futures and options is the fact, the sale as specified in the futures contract is compulsory, whereas, the sale as specified in the options contract is not, it is solely on the discretion of the parties involved. Also, a futures contract does not require an upfront cost, whereas, buying an options contract requires a premium. A futures contract is an agreement between the parties for buying and selling on a future date. In an options contract, the person buys the right to purchase or sell an asset if and when required. The amount paid for that right, i.e. contract is separate from the strike price.

Furthermore, a major difference between futures and options is the way in which the party receives gain. According to Investopedia, “the gain on an option can be realized in three ways: exercising the option when it is deep in the money, going to the market and taking the opposite position, or waiting until expiry and collecting the difference between the asset price and the strike price.” Whereas, “gains on futures positions are automatically 'marked to market' daily, meaning the change in the value of the positions is attributed to the futures accounts of the parties at the end of every trading day.” Also, “a futures contract holder can realize gains also by going to the market and taking the opposite position.”

Image Courtesy: blog.traderwerks.com, teagasc.ie

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