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Chapter 2.9: Difference between futures and options
Derivatives are instruments that derive their value from an underlying security like a share, debt instrument, currency or commodity. Futures and options are the two type of derivatives commonly traded. Investing in futures and options with Kotak Securities can help make your financial infrastructure secure.
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.
Such an agreement works for those who do not have the money to buy the contract now but can bring it in at a certain date. These contracts are mostly used for arbitrage by traders. It means traders buy a stock at a low price in the cash market and sell it at a higher price in the futures market or vice versa. The idea is to play on the price difference between two markets for the same stock.
In case of futures contracts, the obligation is on both the buyer and the seller to execute the contract at a certain date. Futures contracts are special types of forward contracts. They are standardized exchange-traded contracts like futures of the Nifty index.
An Option gives the buyer the right but not the obligation. As a buyer, you may choose to let the option to buy call or put option lapse. The seller has an obligation to comply with the contract. In the case of a futures contract, there is an obligation on the part of both the buyer and the seller.
Options are of two types - Calls and Puts options:
'Calls' give the buyer the right, but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.
'Puts' give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date.
If the buyer of options chooses to exercise the option to buy, the counter-party (seller) must comply. A futures contract, on the other hand, is binding on both counter-parties as both parties have to settle on or before the expiry date.
Please note that all option contract available on NSE can be exercised on expiry date only
How Futures and Options contracts differ
If you are a buyer in the futures market, there is no limit on the profit that you make. At the same time, there is no limit on the loss that you make. A futures contract carries unlimited profit and loss potential whereas the buyer of a Call or Put Option's loss is limited, but the profit potential is unlimited.
Purchasing a futures contract requires an up front margin and normally involves a larger outflow of cash than in the case of Options, which require only the payment of premium.
Futures are a favourite with speculators and arbitrageurs whereas Options are widely used by hedgers.
While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore is obliged to sell/buy the asset if the buyer exercises it on him. Presently, at NSE, futures and options are traded on the Index and single stocks.
You have now studied all the important parts of the derivatives market – what are derivatives contracts, different types, futures and options, call and put contracts, and how to trade these. Congrats! Let’s wrap this section and move on to the next – mutual funds.
Why Capital gains report?
- Snapshot of profit/loss
- Reflects performance of your portfolio
- Helps compute taxes
Read about derivatives