Options v/s Futures v/s Forwards

08/09/2022 0 By indiafreenotes

An options contract gives an investor the right, but not the obligation, to buy (or sell) shares at a specific price at any time, as long as the contract is in effect. By contrast, a futures contract requires a buyer to purchase shares and a seller to sell them on a specific future date, unless the holder’s position is closed before the expiration date.

Options and futures are both financial products investors can use to make money or to hedge current investments. Both an option and a future allow an investor to buy an investment at a specific price by a specific date. But the markets for these two products are very different in how they work and how risky they are to the investor.

Difference between Futures and Forwards

A forward is similar to a futures contract in that it specifies the future delivery of an underlying asset at an agreed price. However, forwards differ from futures in several ways:

  • Purpose: Forward contracts are almost always held until expiration and physically settled because the counterparties are interested in exchanging the underlying asset for cash. Physically settled future contracts might be held until expiration for traders who want to buy or sell the underlying. But most futures traders are speculating on the price of the underlying, hoping to make a profit from favorable price movements without taking or making delivery.
  • Source of contract: A forward contract is a customized contract, privately traded directly between two identified counterparties. This is called over-the-counter trading and doesn’t involve a futures exchange. In contrast, futures contracts are only available on futures exchanges. You must set up a futures brokerage account to buy and sell these contracts. A futures trader does not directly transact with a counterparty; instead, a futures clearing house mediates all transactions it acts as the buyer to sellers and the seller to buyers.
  • Contract terms: A forward contract is completely customized according to the wishes of the buyer and seller. In addition, forward contracts have no built-in default protection, though a custom default-protection scheme can be negotiated and included. Futures contracts are highly standardized and guaranteed against default. Their expiration date, delivery date, delivery point, amount of underlying asset and settlement terms cannot be negotiated the only decisions open to a trader are how much to bid or ask, when to close out the position and to select financial or physical settlement, the contract expiration month and the number of contracts.
  • Settlement procedures: Forwards are settled at expiration and perhaps more frequently if both participants agree there is no automatic daily cash settlement. Futures are cash-settled every trading day.
  • Margin requirements: Forward contracts typically have few margin requirements, if any. Futures exchanges require traders to deposit into their brokerage accounts a minimum amount of cash per contract, as margin. The deposit is used to guarantee the daily mark to market payment. If the account balance falls below the minimum requirement, then the trader’s broker will issue a margin call a directive to the trader to replenish the account. Failure to do so promptly will lead to a forced offset – the broker closes out the trader’s contracts and adds the cash proceeds to the brokerage account.

Difference between Options and Futures

  • Upfront cost: Buyers must pay a premium to purchase an option, and option sellers collect his premium. There are no upfront costs for futures trades, just margin requirements.
  • Margin requirements: Option buyers do not have to post margin, but option sellers do, unless their options are “covered” by other assets. For example, if an option trader sells a call stock option while owning 100 shares of the underlying stock, the call is covered, and margin isn’t required. All futures trades require margin.
  • Flexibility: The owner of an options contract does not have to execute it – that is, force the trade of the underlying asset for the strike price even if such a trade would be profitable. For physical delivery futures, buyers must take delivery of the underlying asset, and sellers must deliver the asset.
  • Risk: Option buyers can lose no more than the premium they pay. Option sellers and futures traders have unlimited risk on their contracts.
  • Mark to market: Most options, with a few exceptions, are not marked to market every day. An options trader can collect a gain by exercising a profitable option, closing out a profitable option position via offset or collecting profit at expiration. Futures contracts are always marked to market daily, which is the only way to experience gains and losses.
  • Size: Options are generally less expensive than futures, and control a smaller amount of the underlying asset. This means that futures are riskier than options. Of course, option traders can increase their risks by trading multiple options.