Option Trading and Comparison with Future Trading
Option trading is one of the most popular and widely accepted forms of derivative trading in today’s context. Parallel to option contracts, future contracts are also widely accepted derivative contracts and are considered the most widely used hedging instruments. As such a myth or common perception rules that futures and options are the same instruments though it is not true. Future and option serve as a very different market requirement and have their own respective characteristics which give them a diversified portfolio status.
The basic familiarity or similarity between a future and an option contract is that both are mutual contracts or an agreement between a buyer and a seller for an underlying asset. If we consider a future option then a buyer agrees to buy and a seller agree to sell the underlying asset at a predetermined price with respect to a stipulated future time. However in stock option trading the buyer or the seller simply acquire rights to buy or sell the asset in the money market at a future date.
Second difference lies in the terms of payment that the buyer does in order to procure the asset. In case of a future trading a buyer pays a fraction of the price of the underlying asset similar to a down payment. Thus a future contract never comes at a premium in itself. Moreover both the parties in consideration of a future contract are obligated or dutiful to undertake the future contract agreement on the expiration of the contract date. However in case of option trading the buyer or the seller are not obligated to fulfill their contract agreement even at the time of expiry of contract.
The third difference can be attributed to the fact that in case of future trading the price differences are considered and settled on a day to day basis. For instance if the price of the underlying asset moves in the opposite direction then the buyer or the trader needs to add on a top up value which is termed as “ Margin Call”. Thus if the price movement continues in the unfavorable direction the trader would be required to meet the margin call daily. Thus in case of future trading the traders have an unlimited liability thus a very risky proposition if the price movements continue to be averse for an extended time period. However if we consider option trading then in such a case the traders don’t have an unlimited liability and the risk or the maximum losses in option trading are always predetermined.
Another difference that can be outlines is in terms of premium. In case of buying stock options a trader needs to pay a premium but in case of future contracts there are no premiums. As far as obligations are concerned, the buyers of stock options are not under any moral duty to buy the underlying assets at the expiry of the contract but in case of a future contract he buyers are obliged to buy the underlying stock upon expiration. As far as liability is concerned buyer of future are more prone to risk as they have an unlimited liability towards their agreement but the buyers of option trading do not have any unlimited liability.