Trading in the capital market is not restricted to spot contracts, that is, transactions that get executed at the prevailing market price of a financial asset or commodity. Futures and options are amongst the types of contracts prevalent in the market. Both futures and options are derivatives contracts, that is contracts that derive their value from the value of an underlying asset.
In this article, we shall discuss the meaning of futures and options contracts, and the major differences between the two. In order to enter into derivatives contracts in India, you must have a functional trading account.
Meaning of Futures and Options
Futures are a type of derivatives contracts that confer upon the parties thereto the obligation to buy or sell a specific financial asset/ commodity at a predetermined future date and at a pre-decided price.
With such a contract, traders can hedge against potential price fluctuations since the contract creates an obligation to complete the transaction at a fixed price. In order to enter into a futures contract, you must have a brokerage account that carries the permission to engage in futures trading.
Akin to futures, options are a type of options derivatives contracts. Unlike futures, however, options contracts do not create contractual obligations upon the parties thereto.
The holders of an options contract have the option to purchase/ sell a particular financial asset/ commodity until a specific date in the future and at a predetermined price. Such contracts offer traders some flexibility to tackle the risks resulting from the volatility of the market.
Types of Options Contracts
There are two major types of options contracts, namely, call options and put options. While the former creates the right but not the obligation to purchase a security/ commodity at a specific price till a future date, the latter creates the right but not the obligation to sell a security/ commodity at a predetermined price until a date in the future. Both types of options contracts require the buyer of the contract to pay a premium.
Major points of distinction between Futures and Options contracts
Now that we have discussed the meaning of futures and options, let us discuss the parameters on which the two differ with each other. The following table sheds light on the striking differences between futures and options contracts.
| Parameter | Futures contracts | Options contracts |
| Nature of the contract | Futures contracts entail obligations to buy/ sell the underlying financial asset/ commodity. | Options contracts create the right to buy/ sell the underlying commodity without any corresponding obligation. |
| Degree of risk | There is generally a high degree of risk associated with futures contracts. | There is a relatively lower risk associated with options contracts as compared to futures. |
| Potential for gain or loss | Futures contracts carry a high potential for gains as well as losses. | Options contracts are characterised by a high potential for gains but a limited potential for losses. |
| Flexibility | In futures contracts, the parties have low flexibility owing to the obligation aspect. | In options contracts, the parties enjoy a high degree of flexibility since there is no obligation to exercise the buy/ sell option. |
| Timeline for execution | A futures contract can be executed on the date decided at the time of entering into the contract. | An options contract can be executed anytime before or on the date decided at the time of entering into the contract. |
To sum it up
Since both futures and options contracts tend to be complex in nature, it is important to understand their meaning, implications, risks, and various possible strategies before entering into options or futures trading.
The choice between options and futures depends on your investment goals and risk appetite. You can, however, use both types of contracts as a part of a diversified investment strategy.
