Page 233 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes Differences between Futures and Options

The key difference between futures and options is that the former involve obligations, whereas
the latter confer rights. Futures are a contractual obligation to buy and sell at an agreed price at
a future date. The contract terms are standardised by futures exchanges, and the obligation, from
both buyer and seller, is confirmed when the initial margin, or deposit, changes hands. An
option does not carry the same obligations. Buyers pay a premium for the right to purchase (or
sell, in the case of put options) an agreed quantity of some underlying asset by a future date. The
option buyer then has a further decision to make, which is that of exercising his option if he
chooses to buy the underlying asset. In most cases, however, he will take whatever profit there
is available by selling his option back at a higher price (this is why they are known as ‘traded
options’). The futures contract margin is, therefore, the basis of a contractual commitment, while
the option premium represents the purchase of exercisable rights. In both, the concept of gearing
is crucial, although there are differences. Option premiums are a wasting asset, and are much
affected by the volatility of the underlying price. Futures margins are not a wasting asset and are
affected differently by volatility. These key variations causes important differences in the risk/
reward relationships involved in investing in either futures or options. Both futures and options
are useful derivatives but have some fundamental differences between the two types of
derivatives. They are:
Futures Options
1. Both the parties are obliged to perform the 1. Only the seller (writer) is obligated to perform
contract. the contract.
2. No premium is paid by either party. 2. The buyer pays the seller (writer) a premium.
3. The holder of the contract is exposed to the 3. The buyer's loss is restricted to downside risk
entire spectrum of downside risk and has to the premium paid, but retains upward
potential for all the upside return. indefinite potentials.
4. The parties of the contract must perform at 4. The buyer can exercise option any time prior
the settlement date. They are not obligated to to the expiry date.
perform before the date.

Types of Options

Options are classified into two broad categories:
1. Call Option, and
2. Put Option

A call option gives the holder the right to buy an underlying asset by a certain date for a certain
price. The seller is under an obligation to fulfil the contract and is paid a price of this, which is
called “the call option premium or call option price.”
A put option, on the other hand gives the holder the right to sell an underlying asset by a certain
date for a certain price. The buyer is under an obligation to fulfil the contract and is paid a price
for this, which is called “the put option premium or put option price.”
The price at which the underlying asset would be bought in the future at a particular date is the
‘Strike Price’ or the ‘Exercise Price.’ The date on the options contract is called the ‘Exercise date’,
‘Expiration Date’ or the ‘Date of Maturity.’
There are two kinds of options based on the date. The first is the European Option, which can be
exercised only on the maturity date. The second is the American Option, which can be exercised
before or on the maturity date.

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