Question

Suppose a company is looking to hedge a risk in the derivatives market. What, fundamentally, is the difference between hedging in the futures market vs. the options market? Which would you choose for a given situation? Provide examples.

Answer 1

Difference between Futures and Options:

• A future provides the buyer a pre-decided specific rate of shares to be bought from the seller whereas the option provides the right but not the obligation for the buyer to purchase the share at a specific price nay time.
• The amount of risk in futures is more than that of options, because in options the buyer has the right to decline the offer which is not applicable in futures.
• In futures the buyer has obligation to execute the contract, whereas in options the buyer has no obligation.
• In futures there is no advance payment except for commission whereas there is advance payment in the form of premium in options.
• There is no extent of profit or loss in futures whereas there is limited loss in options
• futures are predated whereas options can be executed any time before expiry.

Now, when to choose what:

Futures are traded when the buyer wants to buy the security and has researched about the future market and has predicted the price to rise in the future. In that case the buyer will set a future price to be as low as possible and would hedge the future loss.

Future contracts are quicker than options. so the traders who are more interested in day to day trading , would opt for futures. As they would easily move in and out of the futures.

Futures are more for experienced traders.

Now,

If the trader is a new trader, then he should opt for options, because options are less risky and one cannot loose the investment made by them in options. There is least risk of loss in options. It is more conservative approach, for people willing to take less risk.