Understand the Difference between Derivatives vs Options

People often get confused by the different ways of trading and investing, especially in the stock market. When you open a Demat account for the first time, you may think that the simple way of investing is to buy and sell stocks and try to make profits in this manner. 

However, there are other ways of investing in different assets like stocks and commodities, and you may consider derivatives options. Although these terms may sound confusing at first, they are not difficult to grasp once you understand how they work. 

Options and Derivatives – The Basics

As terms in the stock market, or any investment market, for that matter, may be used interchangeably, it is necessary to clarify concepts. A derivative is defined as a financial contract that possesses its value, term structure, and risk from an underlying asset. 

Options make up a category of derivatives and give the holder of contracts the right, but not the obligation to purchase or sell the underlying asset that the contract represents. Options contracts are available for any kind of underlying assets be it equity, commodities, or currency. 

Derivatives are contracts that are agreed upon by two or more parties in which the value of the contract is based on an underlying security or a set of different assets like an index, for instance. 

For derivatives, the common underlying securities include interest rates, bonds, currencies, market indices, stocks, and commodities. Derivatives have a value or price attached to them and a date of expiry within which the contract must be settled. 

This may be a date in the future, so derivatives are used as a vehicle to hedge risks linked to any portfolio or asset. 

Now you may think that derivatives options are still confusing as the words ‘derivative’ and ‘option’ could very well be the same. What you must understand is while derivatives can represent a gamut of contract types, option is just a category among those types. 

Understanding Options in Detail

When most people talk about options, they think of equity options. This is just one kind of derivative that gets its value from the underlying asset that is equity or stocks. An equity option stands for the right (but not the obligation) to purchase or sell equity or stocks at a particular price (called the strike price) on a specific date or before that date. You may now understand why people get confused between terms as these agreements or contracts may be termed as derivatives options. Derivatives is used as a general term to describe a contract between people and this contract derives its value from an underlying asset. 

Coming back to options, the contracts that fall within this category of derivatives are sold for a price known as the ‘premium’. 

In options contracts, there are call and put option. In a call option, the holder of the contract has the right (but is under no obligation) to purchase the underlying asset (the stock). A put option gives the holder of the contract the right to sell the underlying asset (the stock) but under no obligation to do so. 

Equity options are commonly traded on any stock exchanges and they may be settled via centralised clearing houses. This provides a high degree of liquidity and transparency, which are crucial to investors who expose themselves to derivatives contracts. 

What are derivatives?

While understanding options and derivatives, it is important to grasp what derivatives exactly are. Commonly, derivatives are spoken about as futures contracts whose value is represented by an underlying index or cash commodity. A futures contract is an agreement between parties to purchase or sell a certain asset or a commodity at a pre-fixed price at a current date or a date in the future. 

Futures contracts include a wider range of assets and can comprise underlying assets as diverse as agricultural products to crude oil. In futures contracts, there is an obligation on the part of the holder to see the contract through, whether the holder is potentially experiencing losses or profits. Such contracts, unlike options contracts, are legally binding on contract holders. 

Clarity in Contracts

In the realm of investment, terms are often used interchangeably and this may confuse even the most savvy investors. However, once you know how terms are used, you may be able to differentiate between them easily. Options may be a component in a wider and more general category of asset contracts called derivatives and the use of these often determines what they actually are.