A futures contract is simply a legal agreement between two parties to buy or sell an asset at a certain time in the future at a predetermined price.
There are two parties to every futures contract – the seller of the contract, who agrees to deliver the asset at the specified time in the future, and the buyer of the contract, who agrees to pay a fixed price and took delivery of the asset.
Futures contract are mainly used for hedging but change in prices of the underlying asset of the future contract provide gains to one party at the expense of the other.
The futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement.
A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are:
- Quantity of the underlying
- Quality of the underlying
- The date and the month of delivery
- The units of price quotation and minimum price change
- Location of settlement
Option is basically an instrument that is traded at the derivative segment in stock market. Option is a contract between the buyer and seller to buy or sell a one or more lot of underlying asset at a fixed price on or before the expiry date of the contract.
While buying an option a contract the buyer has the right to exercise the option within the stipulated time period but he or she is not bound to exercise that option. On the other hand if the buyer is willing to exercise the option the seller is bound to honor that contract.
In option trading the price that is agreed up on for trading is called the strike price and the date on which the option contract is going to expire is called the expiration time or expiry. There can be different underlying assets for which options are traded including stocks, index, commodity, derivative instrument like the future contract and so on.
There are mainly two types of option contacts that you can buy or sell at the stock market – ‘Call Option’ and the ‘Put Option’.
Difference between Future Contracts and Option Contracts
|Basis||Future contracts||Option Contracts|
|1. Meaning||A futures contract is simply a legal agreement between two parties to buy or sell an asset on the stated date in future at a predetermined price.||Option is a contract between the buyer and seller to buy or sell a one or more lot of underlying asset at a fixed price on or before the expiry date of the contract.|
|2. Obligations||Future contracts put obligations on the buyer to honour the contract on the stated date.||Option contracts give the buyer only the right but not the obligations to honour the contract.|
|3. Time value of money||Time value of money is not considered in case of future contracts.||Option premium is determined after considering the time value of money.|
|4. Advance payment||No advance payment is required in case of future contract.||Premium paid is treated as advance payment.|
|5. Date of execution||Date of future contracts is pre-decided as per contract.||Date of execution of option contracts is any time before the date of expiry.|
|6. Profit/Loss||In future contract profit or loss is unlimited.||In case of options, risk involved is limited upto the amount of the premium.|