Investment is one way of growing your accumulated savings but there’s always uncertainty and risk involved when it comes to putting money into any avenue. Derivatives are those financial instruments that come to rescue at the time of managing risk. There are different types of derivatives, namely, futures, options, forwards, and swaps. In this article, you will learn about two of them - swaps and options. Along with their basics, you’ll also learn about their differences. Without sound knowledge about these derivatives, taking a leap into investing isn’t a wise move. So, let’s understand the definitions of swaps and options.
What Are Options?
Options is a derivative contract between the buyer and seller. Here, the party to the contract can either buy or sell but are not obliged or mandated to do so. In futures, the party to the contract has to fulfill the contract, but in options, the investor has the choice to carry out the deal or not. The types of options are as follows: call option and put option. This financial derivative is used by the investors or traders to take leverage of the underlying security at a lower price, resulting in minimizing the risk exposure.
What Are Swaps?
A swap is another derivative financial instrument used by two parties when they enter into a swap contract. Here, exchange of cash flows or liabilities takes place between the agreed parties of the contract. An investor or trader exchanges their financial instrument with another investor or trader in the swap contract. While cash flow remains constant, the other varies according to the currency rates, index rates, etc. Swap contracts are done over the counter whereas options are dealt on the stock exchange. There are many types of swap contracts such as interest rate swaps, currency swaps, commodity swaps, foreign exchange swaps, credit default swaps, etc. The major benefit of tradingswaps is that investors get to hedge against any kind of risks associated with the trade.
Difference Between Options And Swaps
Although both options and swaps are derivatives in the financial horizon that are used by the traders or investors to hedge or speculate or take positions in the market, they have their share of differences as well.
- An option is a derivative contract entered by two interested parties, i.e. a buyer and a seller to buy or sell an underlying asset at a predetermined price in the future. However, the deal is not an obligation, but an option to go against it or fulfill. When it comes to swaps, it’s an agreement entered by two traders or investors to exchange cash flows of their respective financial instruments.
- Options can be traded at the public exchanges while swaps can be traded over the counter (OTC).
- Traders have to pay a premium to enter the option contract whereas swap traders don’t need to pay anything of that sort.
- In options, the actual value of the underlying assets are traded, whereas, in swaps, the exchange takes place in the form of cash flows and liabilities, if any.
- In options, the common types of strategies used are Call and Put, whereas, in swaps, the strategies used to hedge against or manage risk are interest rate swaps, foriegn exchange swaps, and commodity swaps.
Conclusion
Swaps and options are two financial derivatives both carrying different characteristics. While these two derivative products are used by traders to either speculate risk or hedge against volatility, they benefit the traders or investors irrespective of the ups and downs in the market when put to good use. Now, if you are planning to explore the derivative trading market, open a demat account at a trustworthy broking entity and kick start your investment journey.
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