Difference Between Futures and Options
Futures and options represent two of the most
common form of "Derivatives". Derivatives are financial instruments
that derive their value from an 'underlying'. The underlying can be a stock
issued by a company, a currency, Gold etc., The derivative instrument can be
traded independently of the underlying asset.
Derivatives are products
that are linked to the value of an underlying share or index. When the NSE
launched equity derivatives in June 2000, very few people understood them. In
the first month, barely 1,200 contracts worth Rs 35 crore were traded on the
bourse.
The value of the derivative instrument changes according
to the changes in the value of the underlying.
Derivatives are of two types -- exchange traded and
over the counter.
Exchange traded derivatives, as the name signifies are
traded through organized exchanges around the world. These instruments can be
bought and sold through these exchanges, just like the stock market. Some of
the common exchange traded derivative instruments are futures and options.
Over the counter (popularly known as OTC) derivatives are
not traded through the exchanges. They are not standardized and have varied
features. Some of the popular OTC instruments are forwards, swaps, swaptions
etc.
FUTURES
A futures contract is an agreement between two
parties to buy or sell an asset at a certain time in the future at a certain
price.
Such an agreement works for those who do not have the
money to buy the contract now but can bring it in at a certain date. These
contracts are mostly used for arbitrage by traders. It means traders buy a
stock at a low price in the cash market and sell it at a higher price in the
futures market or vice versa. The idea is to play on the price difference
between two markets for the same stock.
In
case of futures contracts, the obligation is on both the buyer and the seller
to execute the contract at a certain date. Futures contracts are special types
of forward contracts. They are standardized exchange-traded contracts like
futures of the Nifty index.
A futures contract gives
you the right to buy or sell shares at a specific price in the future. The
future price is usually higher than the prevailing market price of the security. Futures and options are sold in lots.
Highpriced shares are offered in small lots, while low-priced shares are available
in big lots.
Futures and options expire
on the last Thursday of a month. It’s possible to roll over a future by buying
the next month’s contract, but it is not possible to roll over an option.
Stock derivatives are
available for up to three months in the future. So, in March, you can buy stock
futures and options for March, April and May. But index derivatives can be
bought up to three years in advance.
Futures contracts are
leveraged instruments. The investor pays just 20-25% of the value of the
transaction as margin money. A 1% change in the share’s value means a 4-5%
change in the value of the contract. The loss incurred is deducted from the
margin and the investor is asked to pay the additional margin. If he can’t pay,
the shares are sold.
Contract
size: The
value of the futures contracts on individual securities may not be less than
Rs. 5 lakhs at the time of introduction for the first time at any exchange. The
permitted lot size for futures contracts & options contracts shall be the
same for a given underlying or such lot size as may be stipulated by the
Exchange from time to time.
Price
steps: The
price step in respect of futures contracts is Re.0.05.
Base
Prices: Base
price of futures contracts on the first day of trading (i.e. on introduction)
would be the theoretical futures price. The base price of the contracts on
subsequent trading days would be the daily settlement price of the futures
contracts.
Price
bands: There
are no day minimum/maximum price ranges applicable for futures contracts.
However, in order to prevent erroneous order entry by trading members, operating ranges are kept at +/-10 %. In respect of orders which have come under price freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order.
Quantity freeze: Orders which may come to the exchange as a
quantity freeze shall be based on the notional value of the contract of around
Rs.5 crores. Quantity freeze is calculated for each underlying on the last
trading day of each calendar month and is applicable through the next calendar
month.
OPTIONS
An option gives a person the right but not the obligation
to buy or sell something. An option is a contract between two parties wherein
the buyer receives a privilege for which he pays a fee (premium) and the seller
accepts an obligation for which he receives a fee. The premium is the price
negotiated and set when the option is bought or sold. A person who buys an
option is said to be long in the option. A person who sells (or writes) an
option is said to be short in the option.
Like futures contracts, options
also give you the right to buy (through a Call option) or sell (through a Put
option) a share at a future date. But you are not under any obligation to do
so.
Calls: When you buy a Call, you are buying shares of the underlying scrip at a specified price. If the share price goes up, the value of the Call also rises.
Puts: Buying a Put option means you are selling the shares at a
specified price. If the price of the underlying security falls, the value of
the Put rises.
Index options: If it
is an index option, the option can only be exercised on the expiry date. These
are European types of options and are denoted as CE (Calls) and PE (Puts).
Stock options: If it
is a stock option, it can be exercised at the end of any trading day. These are
American types of options and are denoted as CA (Calls) and PA (Puts).
Options are available for stocks and
indices at price intervals called the strike price. For instance, if the price
of the underlying share is Rs 100, options will be available in intervals of Rs
5. For an index, the strike price may be in intervals of Rs 50. The price paid
for an option is called the premium. At the beginning of the contract month,
the probability of a share moving in either direction is higher, so the premium
is usually high. As the expiry date nears, the premium goes down progressively.
EXERCISING THE OPTION
A buyer can sell the option for a profit
(or loss) on any trading day based on his reading of the market. He can also
exercise a stock option if the transaction is profitable.
On the exercise and the expiry dates, the
value of a Call option is calculated as follows:
Value of Call = Market price of share —
Strike price
For a Put option, the calculation is the
reverse:
Value of Put = Strike price — Market price
of share
HOW FUTURE AND OPTION CONTRACTS DIFFER
If you are a buyer in the futures
market, there is no limit on the profit that you make. At the same time, there
is no limit on the loss that you make. A futures contract carries unlimited
profit and loss potential whereas the buyer of a Call or Put Option's loss is
limited, but the profit potential is unlimited.
Purchasing a futures contract requires an up front margin
and normally involves a larger outflow of cash than in the case of Options,
which require only the payment of premium.
Futures
are a favourite with speculators and arbitrageurs whereas Options are widely
used by hedgers.
While
a buyer of an option pays the premium and buys the right to exercise his
option, the writer of an option is the one who receives the option premium and
therefore is obliged to sell/buy the asset if the buyer exercises it on him.
Presently, at NSE, futures and options are traded on the Index and single
stocks.