Two very popular derivative instruments in the equity markets are futures and options. First the similarities! Both futures and options are derivative products in the sense that their value is derived from the underlying asset. This underlying asset could be in the form of an equity share or an index. Secondly, both are contracts meaning that you cannot hold futures or options in your demat account. They are just contracts to remain in your trading account and to be squared off. But as products they are vastly different in terms of risk, returns etc. Let us look at some of the key differences between futures and options.
- Futures are symmetric but options are asymmetric
What does symmetric mean? It means that the profits and losses can be unlimited for the buyer and the seller. For example if A buys Nifty futures at 10,100 and B is the seller then how do their cash flows get impacted. If the futures go up to Rs.10,150 then A will make a profit of Rs.50 and B will make a loss of Rs.50. Of course, in reality B will put a stop loss and cut his losses but let us not complicate matters for now. In short when it comes to futures, both the buyer of the future and the seller of the futures have a similar risk and return profile under different price conditions.
What do we mean by an option is asymmetric? An option is a right without an obligation. There is the buyer of the right and the seller of the right. Right comes with a price tag which is the option premium. The buyer of the option pays the premium to the seller of the option for getting a right without the obligation. The buyer’s total loss is restricted to the option premium irrespective of the movement on the downside. On the upside, the profits are unlimited. For the seller of the option, the income is limited to the option premium but losses can be unlimited.
- Structure of the option is more complicated than futures
Let us look at the basic structure of the futures. When you buy futures, you pay a margin and any upside movement is your profit while downside movement is your loss. When you sell options, again you pay margins and any downside movement is your profit while upside movement is your loss. This is simple and plain vanilla just like a cash market position. The only difference is that in cash market position you pay the full money whereas in case of futures you only pay the margin. In short, if you are bullish you buy futures and if you are bearish you sell futures.
In case of options, the view can be either bullish or bearish. If you are bullish, you buy a call options and if you are bearish you can buy a put option. A call option is a right to buy while a put option is the right to sell. Seller of a call believes that the price of a stock will not go above a level while the seller of a put believes that the stock will not go below a particular level.
- Margining differs for futures and options
Both futures and options are leveraged products. That means with a small margin you can take a bigger position. This is a slightly more nuanced topic. When you buy or sell futures then there is an initial margin which consists of VAR margins and Extreme Loss Margins. This is the starting margin. Then there is the mark to market (MTM) margin that you need to pay when the price movement is against you. The margining logic for the buyer and seller of the futures is almost the same.
In case of options, the buyer only has to pay the premium margin since that is the maximum loss. However, the seller of the option will have to pay VAR, ELM and MTM like a futures position. Only the amount gets reduced by the amount of premium received.
- Concept of transaction value is different for futures and options
When it comes to futures the concept of the transaction value is the notional value. Let us understand this better. If you one lot of Nifty consisting of 75 units at the price of 10,000 then the transaction will be considered to be Rs.7.50 lakhs, although the margin you may have to pay will just be 1/5th. The brokerage and the STT will be calculated on the transaction value of Rs.7.50 lakhs. In case of options, the transaction value is defined as the premium value. So if you bought a Nifty 10,000 call option at a premium of Rs.100, then the transaction value will only be Rs.7,500. The brokerage and the STT will be calculated on this value. That is one of the major reasons why options trading became so popular in India.
- Futures and options differ in terms of their application
Actually, futures and options can be used to reduce or hedge the risk of your cash market position. However, there is a vital difference in the way it is used. In case of futures, they can be used either to lock in a profit or loss in a particular position. For example, if you are long on Reliance at Rs.950 in the cash market and short on futures at Rs.1000 in the futures market, then this gap of Rs.50 is your profit and that is locked in. It does not matter whether Reliance goes 10% higher or 10% lower. That is where options have a bigger role to play due to their asymmetric nature. If you are long on cash market positions, you can either buy lower puts to hedge or sell higher calls to reduce the cost or even do both. As a strategy planner, options are a lot more flexible and resourceful.