Among many tools in the stock market world, two very important ones are widely used by investors. These two tools are futures and options.
These are closely related to the contracts exchanged between buyers and sellers of an asset. These two are very different, even though they look similar.
Key Takeaways
- Futures contracts are agreements to buy or sell an asset at a predetermined price on a specified future date. In contrast, options contracts give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price before or on a specified expiration date.
- Futures contracts have a legal obligation to fulfill the terms of the contract, whereas options contracts offer flexibility, allowing the holder to decide whether to exercise the option.
- Futures carry a potentially unlimited risk for both the buyer and seller, while options limit the risk for the buyer to the premium paid and offer potentially unlimited gains.
Futures vs Options
Futures contracts are standardized and traded on exchanges, allowing buyers to lock in a price and investors to bet on future price movements. Option contracts are traded on exchanges or over the counter and can be used for hedging or speculation, allowing investors to make bets on future price movements.
The futures contract is a very well-known financial contract between investors. Speculators and arbitrageurs mostly prefer it.
The futures contract buyer is obligated to honour the contract and must purchase the fixed future date, irrespective of any security-related circumstance.
The options contract is yet another financial contract that is very popular among investors and is mostly preferred by hedgers. In this contract, there is no application for the buyer of the acid to make the purchase.
If the buyer chooses not to purchase the designated date, he is free to do so.
Comparison Table
| Parameters of Comparison | Futures | Options |
|---|---|---|
| Contract Obligation | The buyer is obligated to honour the contract. | There is no obligation on the buyer. |
| Seller | If the buyer chooses to buy, the seller must sell the contract. | Low-margin payment is required. |
| Margin | A high margin payment is required. | Hedgers mostly prefer it. |
| Prefered by | It is mostly preferred by arbitrageurs and speculators. | It is mostly preferred by hedgers. |
| Profit and Loss | Unlimited profit and unlimited loss. | Unlimited profit and limited loss. |
What is Futures?
The futures contract is a very important tool in the world of the stock market, which is closely related to financial investments.
In the futures contract, the two parties involved in buying or selling an asset have an agreement related to that time after purchasing the asset and the price.
There is a compulsion on the buyer in the futures contract to buy the asset on the exact future date, which was specified in the agreement.
There is also a risk related to the futures contract. The risk is that the holder of the futures contract is bound to make the purchase of the asset on the designated future date irrespective of the security moving against them.
There is a chance of unlimited profit in the futures contract and unlimited loss. Therefore it becomes a bit risky to invest in a futures contract. One good thing about the futures contract is there is no upfront cost.
The buyer is ultimately bound to buy the asset on the agreed fixed date while designing the contract. The futures contract is seen to be preferred by speculators and arbitrageurs.
Also, there is a higher margin payment requirement in the futures contract.
What are the Options?
The options contract is another financial investment tool widely used by investors in the stock market while trading. It is best to know the clear difference between a futures contract and an options contract to choose the best option for the investor.
Unlike the futures contract, there is no application for the buyer to buy the asset on any fixed date. The bi is completely free to purchase the asset at a pre-agreed price.
The options contract has a few advantages and therefore appears more beneficial and safe than the futures contract. There is a possibility of unlimited profit in the options contract with just limited loss.
Although, the buyer needs to make an advance payment in the options contract. But making this advance payment gives the buyer a privilege to choose whether they want to buy the asset on the agreed date.
Hedgers mostly prefer the options contract and require a very low margin payment. The buyer in the options contract can execute it whenever they want, but it should be before the expiry date.
Main Differences Between Futures and Options
- In a Futures contract, the buyer is obligated to honour the contract, whereas, in an Options contract, there is no obligation on the buyer.
- In a Futures contract, if the buyer exercises the right, the contract seller must make the purchase. On the other hand, in an Options contract, the buyer can choose whether to move forward with the purchase or not.
- A high payment margin is required in a Futures contract, and a low payment margin is required in an Options contract.
- Arbitrageurs and speculators prefer the Futures contract, while hedgers prefer the Options contract.
- There is unlimited profit and unlimited loss in the Futures contract. In the Options contract, there is unlimited profit and limited loss.
- https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1985.tb02384.x
- https://search.proquest.com/openview/9670211fbeec5a25da7d12fce203462b/1?pq-origsite=gscholar&cbl=48242
Last Updated : 13 July, 2023
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
This is so generic, there is nothing new here.
What a comprehensive explanation of such complex financial tools, it can be quite refreshing to read something so clear, even if it gives so much information.
Investing in the stock market can be so unpredictable, but with well-explained articles like this one, it can be worth it.
Totally, the author did an amazing job at explaining such complex concepts.
I wonder if the author invested on a futures and options before writing this, I need more information about the author before believing everything in the post.
I completely agree, the author did a really good job without necessarily being an investor.
The author doesn’t need to be an investor to give such a comprehensive explanation.
This article explains with such clear details the differences between futures and options, it can be a bit scary to invest in a futures contract, but definitely a very interesting read.
I totally agree. The author did a great job at being objective and clear.
Nice read, but I already knew everything in this post.