Futures and Options Basics

Futures and options are two of the most widely used derivatives in financial markets. Both allow traders and investors to speculate on the price movement of underlying assets, hedge risks, and engage in arbitrage. However, there are key differences between these two instruments in terms of structure, risk, and how they function.

1. Difference Between Futures and Options

1.1. Futures Contracts

A futures contract is an agreement between two parties to buy or sell an asset at a predetermined price on a specific future date. It obligates both parties to fulfill the contract, meaning the buyer must purchase the asset, and the seller must deliver it.

Obligation: Both parties are obligated to buy or sell the underlying asset at the contract’s expiration date, regardless of the market price at that time.
Standardized: Futures contracts are standardized and traded on exchanges (like the NSE, BSE, or Chicago Mercantile Exchange), making them highly liquid.
Settlement: These contracts can be settled in two ways:
- Physical delivery: The actual asset is delivered (e.g., commodities like oil, wheat, etc.).
- Cash settlement: No physical asset changes hands; instead, the difference between the contract price and the market price at settlement is paid.

Key Features of Futures:

Leverage: Futures allow the use of leverage, meaning you only need to deposit a margin to control a larger position.
Risk: The risk is unlimited since both parties must execute the contract, regardless of how much the market moves against them.
Example: If you enter into a futures contract to buy oil at $100 per barrel, and the price of oil rises to $120 per barrel at expiration, you make a profit of $20 per barrel. However, if the price falls to $80 per barrel, you incur a loss of $20 per barrel.

1.2. Options Contracts

An options contract gives the buyer the right (but not the obligation) to buy or sell an underlying asset at a predetermined price, called the strike price, before or on a specific expiration date. The seller (also called the writer) of the option is obligated to fulfill the contract if the buyer chooses to exercise the option.

There are two types of options:

Call options: Give the holder the right to buy the underlying asset at the strike price.
Put options: Give the holder the right to sell the underlying asset at the strike price.
Obligation: Only the seller of the option is obligated to fulfill the contract. The buyer, on the other hand, has the right but is not required to execute the contract.
Premium: The buyer of an option pays a premium to the seller for the right granted by the option. This premium is a non-refundable cost, regardless of whether the buyer exercises the option or not.

Key Features of Options:

Limited risk: The maximum loss for the buyer is the premium paid for the option, but the profit potential is unlimited (for call options) or large (for put options).
Leverage: Like futures, options also offer leverage, as they allow the investor to control a larger position for a smaller upfront investment (the premium).
Example: If you buy a call option for $5 per share on a stock with a strike price of $100, and the stock price rises to $120, you can exercise the option and buy the stock at $100, making a profit of $15 per share (the stock price of $120 minus the strike price of $100, minus the $5 premium). However, if the stock price doesn’t rise above $100, you lose only the $5 premium.

Key Differences Between Futures and Options:

Feature	Futures Contracts	Options Contracts
Obligation	Both parties are obligated to buy/sell at expiration	Only the seller is obligated; buyer has the right
Risk	Unlimited risk for both parties	Limited risk for buyers (premium paid)
Leverage	Available, with margin requirements	Available, with premium payments
Market Movements	Profits or losses based on price changes	Profits for buyers depend on price movement exceeding the premium paid
Use of Premium	No premium paid	Premium paid upfront for the option
Settlement	Physical delivery or cash settlement	Cash settlement or physical delivery if exercised

2. Practical Use Cases: Hedging, Speculation, and Arbitrage

2.1. Hedging

Hedging involves using derivatives to reduce or offset the risk of adverse price movements in an underlying asset. It is similar to buying insurance against price fluctuations.

Futures for Hedging:
- Example: A farmer may use futures contracts to hedge against the risk of falling commodity prices (such as wheat or corn). By selling futures contracts, the farmer locks in a selling price for their crop, ensuring they can sell it at a predetermined price regardless of market fluctuations.
- Risk: The farmer may miss out on potential price gains if the price of the commodity rises, but they have effectively protected themselves against price drops.
Options for Hedging:
- Example: A stockholder holding a large number of shares in a company can buy put options on that stock to hedge against a potential fall in the stock price. If the stock price falls below the strike price of the put, the option will allow them to sell the stock at a higher price than the market price, offsetting the losses from the decline in the stock’s value.
- Risk: The cost of the option premium is the price paid for this hedge. If the stock price doesn’t fall, the investor loses the premium paid for the put options.

2.2. Speculation

Speculation involves using derivatives to profit from the price movements of an underlying asset, without the intention of owning the asset.

Futures for Speculation:
- Example: A trader who believes the price of gold will rise in the future may buy a futures contract to purchase gold at today’s price. If the price of gold increases, they can sell the contract for a profit. If the price falls, the trader faces losses.
Options for Speculation:
- Example: A trader might buy call options on a stock that they believe will rise significantly. The trader only risks losing the premium paid for the call option, but if the stock rises significantly, the potential return is much higher than the premium paid.
- Risk: While the potential profits can be high, the trader risks losing the entire premium if the market moves in the opposite direction.

2.3. Arbitrage

Arbitrage involves taking advantage of price discrepancies between different markets or assets to make a risk-free profit. Derivatives, particularly futures and options, are often used in arbitrage strategies.

Futures for Arbitrage:
- Example: Suppose a futures contract on a commodity is trading at a higher price in one market compared to another. A trader can buy the commodity in the lower-priced market and sell the futures contract in the higher-priced market to lock in a profit.
- Risk: Arbitrage opportunities are generally low-risk, but they require a quick response and substantial capital. The profit margin is often small, and transaction costs may reduce the profitability.
Options for Arbitrage:
- Example: A trader may notice that an asset is underpriced in the options market relative to the spot market. By taking a position in the spot market and simultaneously buying the mispriced options, the trader can capture the price difference, profiting from the arbitrage.
- Risk: Like futures arbitrage, options arbitrage carries minimal risk, but the opportunities are often short-lived, and transaction costs can reduce profits.

Summary

Use Case	Futures	Options
Hedging	Used to lock in prices, protecting against adverse movements.	Used to protect against downside risk while retaining upside potential.
Speculation	Traders bet on price movement by buying/selling contracts.	Traders bet on price movements with limited risk (premium paid).
Arbitrage	Exploiting price discrepancies in different markets.	Exploiting price inefficiencies in the options market.

Conclusion

Both futures and options are essential derivatives with distinct features and uses. Futures offer an obligation to buy/sell at a set price, making them ideal for hedging and speculation, but they also carry unlimited risk. Options provide the right (not the obligation) to buy or sell, limiting the risk to the premium paid, and offering greater flexibility for hedging and speculative strategies.

Understanding the differences and practical use cases of these derivatives is crucial for traders and investors looking to manage risk, speculate on price movements, or exploit market inefficiencies through arbitrage.