Understand the Differences: Options and Futures

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Options and Futures are comparable trading instruments that allow investors to make money while hedging their present assets.

A buyer has the right, but not the responsibility, to purchase (or sell) an asset at a defined price at any point throughout the contract’s duration.

Unless the holder’s position is closed before expiration, a futures contract binds the buyer to acquire a certain item and binds the seller to sell and deliver that asset at a specific future date.

Futures and Options Contracts

Futures and options are both contracts for future performance that are now being negotiated. One party will be profitable by the time the future date arrives, implying that the counterparty will be losing money. 

If the terminal asset price is higher than the starting futures price, the long futures position will benefit, while the short futures position will lose. However, it will be vice-versa, if the terminal asset price is lower than the starting futures price.

The terminal asset price must be greater or lower than the original futures price. As a result, some side is certain to suffer a loss. Hence, both parties must post a performance guarantee or margin at the beginning of a futures transaction. 

Marking to market is the process of adjusting the same daily for gains and losses. As a result, by the time the contract expires, a party’s loss has been transferred to the party that has made a profit. Thus, the threat of default is no longer present.

There is no risk of the purchasers defaulting in options contracts. They will exercise if it is advantageous; otherwise, they will not. Shorts, on the other hand, may default in theory.

In the case of call options, if the terminal spot price is higher than the exercise price, the short may refuse to deliver. In the case of put options, if it is the vice-versa, the short may refuse to take delivery. As a result, all option sellers and writers must make a margin deposit. 

Option writers’ requirement for a margin can be interpreted in the following light. After entering into an options contract, the long will receive either a positive or zero cash flow, while the short will receive either a negative or nil cash flow

Option buyers must pay an upfront non-refundable fee or premium to the option writer since a holder cannot acquire a subsequent negative cash flow, but the counterparty may.

Forward and futures contracts, on the other hand, do not require either party to pay a premium since they may be forced to accept a subsequent negative cash flow.

Because of the bidirectional risk component, both parties to a futures transaction must mark to market. In the case of options, it applies to the writers or shorts because the risk is unidirectional.

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