The main difference between Futures and Options lies in their contractual obligations. Futures contracts require both parties to buy or sell assets, but Options contracts only give the right to buy or sell assets at a certain price and date, not the obligation to do so.
- What Are Futures And Options With Examples?
- Differences Between Futures And Options
- Types Of Options
- Types Of Futures Trading
- Futures And Options Taxation
- Options vs Futures – Quick Summary
- Futures Vs Options – FAQs
What Are Futures And Options With Examples?
In a futures contract, a trader agrees to buy a certain quantity of an asset at a specific price at a future date. For an option contract, a trader purchases the right to buy or sell an asset at a specified price within a specific time period.
Now, consider a futures contract where a trader in India agrees to buy 100 barrels of oil at ₹3000 per barrel for delivery in three months. They are obligated to pay ₹3,00,000 in three months’ time, regardless of the market price. This is how a futures contract works.
On the contrary, take an options contract where a trader purchases a call option to buy 100 shares of Reliance Industries Ltd at ₹2000 per share within the next month. If the share price exceeds ₹2000 during that period, the trader can exercise the option to make a profit. If not, the option can expire, limiting the loss to the premium paid for the option. This is an example of an options contract.
Differences Between Futures And Options
Futures and options are different types of financial contracts. With futures, both parties must complete the deal no matter what. On the other hand, options give you a choice—you can decide whether to buy or sell the asset but don’t have to. So, futures are a must-do deal, while options are a can-do deal.
|Obligation||Both parties must fulfill their obligations under the contract when it expires.||The option buyer has the choice to exercise or not exercise the contract. Option seller must fulfill if the buyer exercises.|
|Rights||Both parties must complete the transaction.||The option buyer has the right, but not the obligation, to buy (call) or sell (put) the underlying asset.|
|Settlement||At the time of expiration, either a physical or monetary settlement will take place.||No obligation for physical or cash settlement. Option buyer decides whether to exercise the contract.|
|Risk||Potentially unlimited risk for both buyer and seller.||Limited risk for the option buyer (premium paid) and potentially unlimited risk for the seller.|
|Profit/Loss||Profit or loss is realized based on the difference between the purchase/sale price and the settlement price.||Profit or loss is determined by the difference between the market price and the strike price minus the premium paid.|
|Flexibility||Offers less flexibility because both parties are bound by the contract terms.||Offers more flexibility as the option buyer can choose whether or not to exercise the contract.|
|Popular Usage||Futures are widely used for hedging, speculation, and managing price risk.||Options are commonly used for hedging, leveraging positions, and speculative trading.|
Types Of Options
Options come in two main types – Call Options and Put Options. A call option confers the right to buy an asset at a specific price within a certain period of time. Conversely, a put option gives the right to sell an asset at a specific price within a designated time period.
For instance, a trader could buy a call option on Infosys shares with a strike price of ₹1400, expiring in a month. If the price of Infosys shares rises above ₹1400 during this time, the trader can buy at the lower price.
Alternatively, a trader might buy a put option on Tata Motors shares with a strike price of ₹220, also expiring in a month. If the price of Tata Motors shares falls below ₹220 in that period, the trader can sell at the higher price.
Types Of Futures Trading
Speculative trading is an important type of futures trading. Speculative trading is when traders buy or sell futures contracts without planning to take physical delivery of the underlying asset. They do this to make money off of expected price changes. It involves betting on price changes to make money, no matter which way the market is going.
Futures trading in India encompasses a variety of asset classes:
- Stock Futures: These futures contracts are based on individual stocks. Trading in stock futures requires an initial margin deposit with the broker. The greater the transaction volume, the higher the potential profit, but the risks are also greater.
- Index Futures: Index futures allow traders to speculate on future fluctuations of indexes such as the Sensex and Nifty. Portfolio managers often use these futures to hedge their equity investments when stock prices fall.
- Currency Futures: These contracts allow risk managers and speculators to trade one currency against another at a predetermined rate on a specified future date. For instance, an importer in India might buy USD futures to safeguard against a potential depreciation of the rupee.
- Commodity Futures: These futures contracts are utilized to hedge against future price fluctuations of various commodities like gold, silver, and oil. Traders also use commodity futures to speculate on price movements. Due to the low initial margins in commodities, futures traders can place large bets, but the risks can be high.
- Interest Rate Futures: These contracts are agreements to trade a debt instrument at a specific price on a particular date. The underlying assets are typically government bonds or Treasury bills, which trade on the NSE and BSE.
Futures And Options Taxation
The taxation of Futures and Options (F&O) trading in India underwent some changes in 2023. The Indian government unexpectedly decided to increase the Securities Transaction Tax (STT) by 25% on F&O trading. This move not only surprised traders and brokers but also created some confusion in the market.
In the Finance Bill 2023, it was stated that the STT on selling options had been increased from 0.017% to 0.021%. However, traders, who were already being taxed at 0.05% since 2016, found the new rate to be a reduction in STT. Realizing the mistake, the finance ministry later clarified that the STT on selling options had been raised to 0.062% from 0.05%. This means that option traders will now have to pay ₹6,200 for every ₹1 crore turnover, reflecting a 25% rise from the previous ₹5,000.
The STT on the sale of futures has also been increased from 0.01% to 0.0125%. Therefore, traders will have to pay ₹1,250 on ₹1 crore of turnover, an increase from the previous ₹1,000.
Options vs Futures – Quick Summary
- Futures contracts must be kept by both parties, but options give the person who bought the option the right to use the contract.
- Futures involve buying an asset at a set price for delivery in the future, while options give the right to buy or sell an asset at a set price within a set amount of time.
- Futures contracts require both parties to fulfill the contract at expiration, while options give the option buyer the right, but not the obligation, to exercise the contract.
- Futures are often used to protect against risk, while options are used to increase the size of positions and trade on speculation.
- Types of Options: Call options give the right to buy an asset, and put options give the right to sell an asset.
- Following are the names of the different types of futures trading:
Stock Futures, Index Futures, Currency Futures, Commodity Futures, Interest Rate Futures.
- Taxes on Futures and Options: The Indian government raised the Securities Transaction Tax (STT) on trading futures and options. Traders must now pay higher STT rates, affecting their trading costs and profit margins.
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Futures Vs Options – FAQs
1. What are the differences between Futures and Options?
The main distinction between Futures and Options is found in the nature of their contractual commitments. Futures contracts obligate both parties to buy or sell assets, whereas options contracts only grant the right, not the obligation, to buy or sell assets at a specific price and date.
2. What are Futures and Options with examples?
A futures contract is an agreement to buy/sell an asset at a specific price on a future date. Example: Buying 100 barrels of oil at ₹3000 per barrel for delivery in three months.
An options contract grants the right to buy/sell an asset at a specific price within a timeframe. Example: Purchasing a call option to buy 100 shares of Reliance Industries at ₹2000 per share within the next month.
3. Which is better, Futures or Options?
Futures offer more obligations and potentially unlimited risk, while options provide more flexibility and limited risk.
4. Can Futures be sold before expiry?
Yes, futures contracts can be sold before expiry in the secondary market, allowing traders to exit positions and realize profits or losses.
5. What happens if an Option expires?
If an option expires, it becomes worthless, and the option holder loses the premium paid for the option.
6. How many days can we hold Options?
Options have specific expiration dates, which can range from a few days to several months, depending on the contract.
7. Which is better, Nifty Futures or Options?
The choice between Nifty Futures and Options depends on individual trading strategies and risk preferences. There is no definitive answer as to which is better.
8. Which is riskier, Options or Futures?
Risk is a part of both options and futures, but the level of risk is different for each. Options have limited risk for the person who buys them (because they pay a premium), but both buyers and sellers of futures may have unlimited risk.
We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, and hence we bring you the important topics and areas that you should know: