Difference between derivative future and option trading

It can be used by investors to obtain the upside of equity-like returns while protecting the downside with regular bond-like coupons. Investors can gain exposure to the equity markets using futures, options and swaps. These can be done on single stocks, a customized basket of stocks or on an index of stocks.

These equity derivatives derive their value from the price of the underlying stock or stocks. Stock markets index futures are futures contracts used to replicate the performance of an underlying stock market index. They can be used for hedging against an existing equity position, or speculating on future movements of the index.

Indices for OTC products are broadly similar, but offer more flexibility. Equity basket derivatives are futures, options or swaps where the underlying is a non-index basket of shares.

They have similar characteristics to equity index derivatives, but are always traded OTC over the counter, i. Single-stock futures are exchange-traded futures contracts based on an individual underlying security rather than a stock index.

Their performance is similar to that of the underlying equity itself, although as futures contracts they are usually traded with greater leverage. Another difference is that holders of long positions in single stock futures typically do not receive dividends and holders of short positions do not pay dividends. Single-stock futures may be cash-settled or physically settled by the transfer of the underlying stocks at expiration, although in the United States only physical settlement is used to avoid speculation in the market.

An equity index swap is an agreement between two parties to swap two sets of cash flows on predetermined dates for an agreed number of years. Swaps can be considered a relatively straightforward way of gaining exposure to a required asset class.

They can also be relatively cost efficient. An equity swap, like an equity index swap, is an agreement between two parties to swap two sets of cash flows. In this case the cash flows will be the price of an underlying stock value swapped, for instance, with LIBOR.

In a futures contract, both parties are obliged to fulfill the terms of the contract at the point of expiration. This is a very significant difference. Buying a futures contract where you will be obliged to buy a particular security at a fixed price carries much more risk than buying an options contract where you have the right to buy a particular security at a fixed price, but are not obliged to go through with it if that security fails to move up in value as you expect. Both parties involved in a futures contract are effectively exposed to unlimited liability.

The costs involved are also different. When an options contract is first written, the writer of it sells it to the buyer and receives the money that the buyer pays. Depending on the terms of the contract, the underlying security involved, and the circumstances of the writer, the writer may have to have a certain amount of margin on hand. They may also be required to top up that margin if the underlying security moves against them. However, the buyer owns those contracts outright and no further funds will be required from them.

With futures, though, as both parties are exposed to losses depending on which way the price of the underlying security moves, they are both required to have a certain amount of margin on hand. Price differences on futures are settled daily, and either party could be subject to a margin call if the value of the underlying security has moved against them. This contributes largely to why futures trading is generally considered riskier than options trading.

Below we look at a couple of the advantages trading options has to offer. As mentioned above, when trading futures you are potentially exposed to big losses whichever side of the contract you are on. If you have the obligation to buy an underlying security at a fixed price and the security moves significantly above that fixed price, then you could lose substantial sums.

Conversely, if you have the obligation to sell an underlying security at a fixed price and the security moves significantly below that fixed price then you could experience sizable losses. If you are writing options contracts and taking on an obligation to either buy or sell an underlying security at a fixed price, then you are exposed to similar risks.

However, you can trade options purely by buying contracts and not writing them. This means that you can limit your potential losses on each and every trade you make to the amount of money you invest in buying specific contracts. Whenever you buy options contracts, the worst case scenario is that they expire worthless and you lose your initial investment.

Even if you do want to write contracts in addition to buying them, you can easily create spreads to ensure that your losses are always limited. The potential for limited liabilities in options trading is a major advantage, particularly for those that are against high risk investments.

Another big advantage options trading offers is versatility. There are a number of strategies that you can use to create spreads that enable you to profit from multi-directional price movements. For example, you could create a spread that would result in profit if the underlying security went down in value a little bit, or if it stayed stable, or if it went up in value by any amount.

This would only result in limited losses if the underlying security went down a significant amount.