Futures are derivative financial contracts that obligate parties to buy or sell an asset at a predetermined future date and price. The underlying assets can be physical commodities or financial instruments. Futures contracts detail the quantity of the underlying asset and are standardised to facilitate trading on a futures exchange.
For example, a futures contract allows an investor to take a chance on the price of a financial instrument or commodity. Futures are used to hedge the price movement of an underlying asset to help prevent losses from unfavourable price changes. When you engage in hedging, you take a position opposite to the one you hold with the underlying asset; if you lose money on the underlying asset, the money you make on the futures contract can mitigate that loss.
Additional Read: What is Futures and Options
Difference between options and futures
Options and futures are financial derivatives, but options give the holder the right without obligation, whereas futures commit both parties to the transaction.
1. Obligation vs. right:
- Futures: When entering a futures contract, the trader is obligated to buy or sell the underlying asset at a predetermined price before a specified date.
- Options: In an options contract, the buyer has the right but not the obligation to buy (Call option) or sell (Put option) the underlying asset at a certain price before a fixed date.
2. Settlement mechanism:
- Futures: Settlement of futures contracts involves the actual buying or selling of the underlying asset at the agreed-upon price.
- Options: Options provide the right to buy or sell, but the execution is at the discretion of the option holder. If they choose not to exercise the option, there is no obligation to buy or sell the underlying asset.
3. Types of contracts:
- Futures: Categorised into financial futures (e.g., Stock, Currency, Index, Interest rate) and physical futures (e.g., Commodity, Energy, Metal).
- Options: Classified as Call options (right to buy) and Put options (right to sell).
4. Risk and profit profile:
- Futures: Traders can profit from both rising and falling markets, but losses can be substantial.
- Options: Provide flexibility for traders to profit in rising markets (Call options) or falling markets (Put options) with limited risk, as the premium paid is the maximum potential loss.
5. F&O trading overview:
- Both futures and options are derivative instruments where traders can buy or sell underlying assets at predetermined prices.
- Traders can profit from price movements—buy positions benefit from price rises, and sell positions benefit from price falls.
6. Financial requirements:
- Futures: Traders need to keep a certain percentage of the future value as margin with the broker to take buy/sell positions.
- Options: Buyers pay a premium to acquire an options contract.
