Your Money – Options & futures: Know the differences

October 25, 2021 12:45 AM

Option buyers have to pay an upfront non-refundable premium to the option writer. Futures contracts do not entail payment of a premium by either party

In the case of calls the holder will exercise only if the spot price of the underlying asset is greater than the exercise price of the contract. Similarly, put holders will exercise if and only if the spot price is less than the strike price of the contract.In the case of calls the holder will exercise only if the spot price of the underlying asset is greater than the exercise price of the contract. Similarly, put holders will exercise if and only if the spot price is less than the strike price of the contract.

By Sunil K Parameswaran

Forward and futures contracts are known as commitment contracts. This is because, once a party enters into such a contract, it has an obligation to perform, irrespective of whether it has earned a profit or incurred a loss. In contrast, options contracts are known as contingent contracts as performance by the holder is contingent on the occurrence of an event.

In the case of calls the holder will exercise only if the spot price of the underlying asset is greater than the exercise price of the contract. Similarly, put holders will exercise if and only if the spot price is less than the strike price of the contract.

Futures and options
Both futures and options are agreements negotiated today with respect to future performance. By the time the future date arrives, one party will have a profit, which obviously means that the counterparty will have a loss. In the case of a long futures position, if the terminal asset price is greater than the initial futures price, the long will have a profit and the short will have a loss. On the other hand, if the terminal asset price is lower than the initial futures price, the short will have a profit and the long will have a loss.

Quite obviously, the terminal asset price must be either higher or lower than the initial futures price. Consequently, one party is bound to incur a loss. Thus futures contracts require both parties to post a performance guarantee or margin at the outset. This is adjusted on a daily basis for gains and losses, which is referred to as marking to market. Thus, by the time the contract expires, the loss incurred by a party is transferred to the party with a profit. Consequently, the specter of default goes away.

Options contracts
In options contracts, there is no possibility of default on the part of the buyers. They will exercise if it is profitable, and they need not do so otherwise. However, in principle shorts may default. That is, if the terminal spot price is greater than the exercise price, the short may refuse to deliver in the case of call options. Similarly, in the case of put options, the short may refuse of accept delivery, if the terminal spot price is lower than the exercise price. Thus, all option sellers or writers must deposit margins.

The need for a margin on the part of option writers may be viewed as follows. Once an options contract is entered into, the long will get either a positive or a nil cash flow, whereas the short will get a negative or a nil cash flow. Since a holder cannot get a subsequent negative cash flow, but the counterparty can, option buyers are required to pay an upfront non-refundable price or premium to the option writer.

This is true for all options, be they calls or puts, European or American. In contrast, because of the fact that either party may have to countenance a subsequent negative cash flow, forward and futures contracts do not entail the payment of a premium by either party. Because of the bidirectional risk factor, marking to market applies for both parties to a futures contract. However, in the case of options, it applies only to the writers or the shorts since the risk is unidirectional.

The writer is CEO, Tarheel Consultancy Services

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