Stocks vs. Futures vs. Options: A Beginners Guide
The most common entry point when you’re considering investing in the market is stocks and shares. But once you get in, you will also hear about futures trading and options trading. Let’s do a quick overview of what each term means and compare and understand them better.
What Are Stocks?
Stocks are essentially a share of a company’s ownership. When you buy a stock, you have invested in the company and are entitled to a part of the profit the company makes.
If you’ve bought stocks of a well-performing company, then the prices go up, and you make a profit if you sell at that high price. If the company is not doing well, then your stock price goes down and you will lose money if you sell then.
What Are Futures?
A futures contract is an agreement to buy and sell a particular commodity or stock at a fixed price at a future date. The selling price will not change even if the delivery date is far away, and the actual price on the delivery date is higher than the contracted price. Additionally, the buyer and seller cannot refuse to honour the contract—the purchase and sale must take place.
Confused? Let’s give you an example. Say you enter a futures contract to purchase 500 stocks of a company at a price of Rs.250 per share. The delivery date agreed upon is 3 months from today. Now, 3 months later, the actual market value of the stock has reached Rs.300. But when you get the delivery, you will only pay Rs.250 per share and not Rs.300.
Futures contracts are a derivative financial instrument—this means that their prices are derived from, or is dependent on, a particular asset such as a commodity or stock. You are not actually buying the stock or commodity; you are actually buying and selling money.
What Are Options?
Options contracts are also derivate in nature, and you don’t purchase any physical commodity in this trade.
There are two types of options contracts: call options and put options. Whoever has call options is entitled to, but not obliged to, buy the underlying asset, and whoever has put options is entitled to, but not obliged to, sell the base asset.
This means that agreeing to buy a call option has less risk while agreeing to sell a put option has less risk. In contrast, agreeing to sell a call option and agreeing to buy a put option is riskier.
You have to pay a premium price to enter into an options contract. The price at which you buy or sell the underlying asset of the options you hold is called strike price or exercise price. The purchase or sale should be done within the expiration date—the last date to exercise (buy or sell) your options.
Similarities and Differences Among Stocks, Futures, and Options
The three main similarities among stocks, futures, and options are:
- You must have a demat trading account to buy or sell them.
- The trading is done for all of them through exchanges and brokers.
- The prices of all three keep fluctuating throughout the day, impacted by a variety of market conditions.
Nowadays, you can trade in all of them on your own online. However, if you’re not well-versed in the market, you should go through a reliable broker or brokerage firm.
The differences between the three are:
- The stock exchange involves direct trade of a company share, while futures and options are a trade of derivative stocks or commodities.
- While you will get share certificates for stocks, futures and options are financial contracts and not an actual trade in stocks or commodities.
- Stock-trading is a spot activity, while futures and options are contracts or promises that are executed later, usually 1, 2, or 3 months.
- Stocks are a straightforward purchase and sale at a profit or loss and is more definite. Futures and options are speculative and riskier in nature and can be used for hedging.
- Stocks do not have any premium or upfront fees. With futures, you will be paying a margin, or an upfront amount at the time of signing the contract, as a surety. With options, you must pay a premium amount, over and above the price decided for the underlying security, to be able to hold them.
- In a futures contract, you are obliged to buy and sell irrespective of what the prevalent rates are on the delivery date, while in an options contract there is no obligation to buy or sell.
- A futures contract is fulfilled on the agreed-upon delivery date, while an options contract can be fulfilled any time up to the expiration date.
In a nutshell, the key differences among stocks, futures, and options are:
Which Is Better: Stocks, Futures, or Options?
There is no right answer to that. All of them are investment avenues that you can profit from, but ONLY IF you know enough about the equity market. You need to know when to buy an asset, when to sell in order to make a profit, and when to exit the market to avoid losses.
For beginners, stocks are the easiest to understand. Options contracts tend to have complex clauses, but since you are not forced to buy or sell, your loss can be minimised. Futures are probably the riskiest of the three because you are pretty much guessing a future price based on the day’s price—and praying to god that no global disaster turns the tide against you—AND you are forced to honour the contract and buy or sell even if it’s at a great loss. So, futures and options need to be traded in cautiously.
There is a higher chance of you being able to handle stock-trading on your own, but for futures and options, it’s best to take an expert’s help.