A derivative is an instrument which is derived from an underlying asset. The price is determined by the fluctuations in the price of the underlying assets. The common types of derivatives are options and futures. Derivatives are similar to insurance as they allow to transfer the risk from one party to another
An option is a derivative contract that gives the buyer an option of buying or selling the underlying assets. It is an agreement between two parties to buy or sell an asset for a predetermined price at a future date. It is specified already in the contract. An option can be either created on the OTC market and customised according to the terms of each party. In addition to this, an option can be a standardised contract that is created and traded on the options exchange.
An option contract can be exercised before the expiration date of the contract or only at expiration. An option that is exercised before the expiration date is called an American style. Further, an option that is exercised only on expiration is referred to as European style.
There are two types of options namely:
Call option –
A call option gives the buyer of the option the right but not the obligation to buy the underlying asset. It is at a specified price after a predetermined period. A call option can be purchased for various different asset classes which includes ETF’s, stocks, commodities etc.
The are various different ways to use the call option to earn money but the buyer must be aware of time value and volatility.
Put option –
It gives the buyer of the option the right but not the obligation to sell the underlying asset.
For eg: Mr A has 1000 shares of Rs. 100 each and believes that the share price will rise in 1 month but is sceptical about it and wants to hedge against price risk. Therefore, he buys a put option for selling 1000 shares of 100 each after 1 month. At the end of the period the price goes down to rs 90 which would give loss thus getting into a put option, Mr A can sell the shares at 100 and incurring a loss of just the premium amount paid for the contract.
But if the price would have gone up to Rs. 110 then he would use the option to deny the contract and not sell the shares in Rs. 100 and instead sell it at market price.
A Future is a standardized contract that is created and traded on a Futures Exchange. NSE is one of the futures exchange in India. These contracts have an agreed upon price and predetermined future date. In these contracts, two parties agree that one party i.e Buyer will purchase an underlying asset from another party i.e. seller at a date agreed upon and at a price agreed upon. Further, the daily loss and gains are settled and credit guarantee is made by the futures exchange via their clearing houses.
The important characteristics of a future contract are the daily settlement of the loss and gains. Also, it provides the associated guarantee that is provided by the exchanges through its clearing house.
For eg: If Mr A wants a bulk of cotton for his manufacturing of shirts 3 months from now but he estimates that the price of cotton would rise so gets into a future contract with a cotton seller to deliver cotton on an agreed price 3 months from the contract date. After 3 months his estimation was correct, prices of cotton did rise but he was hedged by the futures contract. The seller was thus obligated to sell the cotton on the agreed price thus bearing a loss.
1) A futures contract is an agreement that has predetermined prices and dates. In a future contract, parties can buy or sell the asset at the specified price. An options contract is where they buy of the asset has the right but not the obligation to buy or sell the underlying asset.
2) The risk involved in a futures contract is higher as compared to the risk in the options contract is limited to the premium paid on the agreement.
3) Buyers are obligated to buy or sell the underlying asset in the futures contract. In an options contract, there is no such obligation. Whereas for sellers, options contract has a slight obligation because the buyers have the option of buying or selling the underlying assets and in futures, there is a full obligation.
Nature of Contract:
5) Futures are standardized contracts with different maturity periods. An options contract has two types call and put which describe the nature of the contract. Options contract its an OTC as well as a standard contract.
6) The options contract gives an opportunity to the buyer during a high-risk situation. Therefore a small percentage of the entire amount of options contract is paid while buying or selling it called the premium. No advance payment is required in futures except for the commissions paid to the intermediaries.
7) In future contracts, there is unlimited profits as well as losses which means there are no restrictions on the profits or losses that a person can gain or lose. While in options contracts the extent of gains or profits is unlimited whereas the loss is to the extent of the premium paid.
Execution of the contract
8) Futures contract are compelled to be executed at the predetermined dates and at the specified price as mentioned in the contract. It is not the same in the case of options, it can be executed at any point in time before the expiry date.
Time value of money:
9) The time value of money is not considered in future contracts. It is because there is a risk of price changes in the future. Whereas, options contracts are heavily dependent on the time value of money. As parties have an option to minimize the losses in case of any price change in the future. It is mandated to execute futures contract there is no consideration of the time value of money. Whereas in an options contract the buyer has an option to execute the contract. The premium amount is also calculated by applying the time value of money.