Futures and options are the main types of derivatives trading in the stock market. These are contracts to trade securities at a specified price on a given future date. These try to hedge against risks by agreeing on a specific amount to trade when the time comes.
Traders undertake these derivative contracts to make profits through speculation of future market prices. However, the stock market may go down, meaning a trader will suffer from the drop in stock value. It’s therefore prudent to enter into futures or options to hedge against a possible loss that may occur.
What Is Futures Trading?
This is a contract where a party agrees to buy shares at a pre-established cost at a certain time in the future.
Types of Futures
Here are the various types:
- Index future– this type of contract entails the underlying value of the assets based on that of the stock index, which helps assess changes in the cost of a group of stocks over time.
- Stock future is a contract that gives a trader the power to purchase or sell securities at a given price and date. Once you buy this contract, you must uphold the terms of the agreement.
- Interest rate futures– these are contracts with an asset that pays interest rate and they can be cash settled or involve delivery of the security itself at a predetermined amount.
- Currency and commodity/FX futures– these are contracts for exchanging a particular amount of currency at a given time.
What is Options Trading?
It’s a derivative contract that gives a trader the right but not obligation to trade an asset at a specified date.
Types of Option Trade
They include:
- Call options– enables a buyer to acquire an asset at a given amount and date. An investor will purchase these options when they have a bullish view of the price in the future.
- Put options– allows a seller to dispose of stocks at an agreed-upon amount at a given date in the future.
Differences Between Futures and Options
Futures and options are the most common types of derivatives but they come with the following differences:
- Futures are super easy to understand, which makes them easy to purchase compared to options.
- In matters of risk, futures are more volatile than options. Risk to an options buyer is limited to the premium amount.
- Futures restrict buyers to transact the exact amount on a given date, but, in options, parties have a right but not obligation to transact the shares.
- In the case of options, the seller needs to pay a premium which is a small percentage of the price, but in futures, there is no need to pay any advance.
- Options rely heavily on the time value of money, but that’s not the case in futures.
Key Takeaways
- Both are derivatives that give a trader the chance to hedge investment against risk.
- Options give a seller the opportunity but not obligation to sell an underlying asset such as stocks at a specified date and time.
- Futures bind a party to purchase an asset, and the seller needs to deliver the asset as agreed.
- Futures are traded on the stock market, but options trading occurs both on and off the exchanges.
- Futures are far more liquid and have more uses than options, making them more popular.
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