Question

One distinguishing difference between the buyer of a futures contract and the buyer of an option contract is that the futures buyer:

A) Pays a much higher premium than option buyers

B) Has an obligation to purchase, not a choice

C) Can lose no more than initial premium

D) Has increased rather than reduced risk

Answer 1

Difference between buyer of Future Contract and option contract

The main difference between the buyer of future contract and option contract is that that the buyer of future contract pays no initial premium whereas the buyer of the option contract pays an initial premium. The premium is paid for purchase of right. The right to exercise or abstain from exercising the said contract.

Eg. Say Mr. A and Mr. B both needs to buy a share of Microsoft after 3 months. Mr. A enters into a futures contract (F+) to buy a share of Microsoft after 3 months at a strike price of $20/- per share. Mr. B enters into an option contract to buy the share of Microsoft after 3 months at an exercise price of $20/- per share. Mr. B also pays an initial premium of $2/-. On maturity it is seen that the share price on that date is $15/- per share.

In such a case, Mr. A shall be obligated to buy the share at $20/- in spite of the fact that the share is currently trading at $15/- per share and he could have bought it at $15/-. Thus he is obligated to exercise the contract at strike price and he has no choice of not executing the contract.

Mr. B on the other hand owing to the fact that he paid a premium of $2/- has obtained the right for not executing the option contract if he so chooses. In case the share is trading at $15/- per share, the option contract shall lapse and Mr. B shall purchase the share at market price of $15/-. But it is to be noted that Mr. B will also lose the initial premium paid. Thus his effective cost shall be $15 + $2 =$17/-. Thus in an option contract he shall have the right to lapse the contract if it doesn’t turn out in his favor.

Based on the given explanation, the answer would be option B. i.e the future contract buyer shall have an obligation to purchase the underlying asset and not a choice to buy.