Derivatives are financial instruments whose value is dependent on underlying assets. You can trade in derivatives through future contract and options contract. Future trading and options trading constitutes an important chunk of derivative trading.
If you want to start doing derivative trading then it is important that you understand the concepts of futures trading and options trading. Futures and option are both trading tools which have the potential to let you earn profits. Both have some stark differences which you need to know so as to choose what type of derivative trading you want to do.
Options Trading v/s Futures Trading
An options contract is a contract where the investor gets a right to buy or sell a share at a specific price until the contract is in effect.
A futures contract is where the buyer has to buy the shares and the seller has to sell those at a specified price and date in the future.
In options trading, the investor has no obligation to do the trade. As mentioned above it gives a right to an investor to do the trade but no compulsion to do so. But if the buyer has chosen to buy an asset then the seller is obligated to sell it.
In futures trading, the investor has an obligation to do the trade. The future contract binds the two parties into a contract and they have to trade before the contract expires.
In options trading, the investor has the advantage to mitigate the risk. For eg, if an investor has agreed to the price of an asset and the price of the asset fall below the agreed upon the price, then the investor can opt out from the contract. This helps the investor to limit the losses.
Whereas in futures trading, if an investor has agreed to buy a security at a pre-decided price and date in the future, then no matter the state of that security, the investor is bound to buy it. So if the investor has decided to buy a security at an agreed price, and the market value of the asset falls as the contract expiry approaches, the investor cannot opt out and will have to bear the loss. This makes future trading riskier than options trading.
In options trading, whether or not an investor does the trade, he/she has to pay a premium. This payment is what gives the investor the right to opt out of the contract if the value of the asset falls. If the investor opts out then the only loss is the premium amount paid.
In futures trading, there is no premium as such but as the deal is sealed, the investor has to pay the agreed upon price.
Date of Execution of Contract
In options trading, an investor can execute the trade at any point in time, given it is before the contract expires. This gives you the advantage of buying an asset when you feel the time is right.
In futures trading, the contract is executed on the pre-decided date.
Futures trading and option Trading are both powerful tools in derivative trading. Make sure you understand your investment and risk-taking capacity before decided which contract to use.