Futures vs options: Which is Better?
In recent years, futures and options have gained popularity among investors, especially in the stock market. This is because they offer several advantages, such as lower risk, leverage, and high liquidity.
Futures and options are a specific type of financial instrument called derivatives. Derivatives get their value from an underlying asset, and they are available for various assets like stocks, indices, currencies, gold, silver, wheat, cotton, petroleum, and more. In simple terms, any commodity or financial instrument that can be bought or sold can have a derivative associated with it.
Futures and options serve two main purposes: hedging and speculation. When prices are volatile, they can lead to losses for producers, traders, and investors. In such situations, these derivatives can be useful for hedging against such price fluctuations. On the other hand, speculators use derivatives to profit from price movements. By accurately predicting price changes, they can make money through these derivatives.
Difference Between Futures and Options
Let me explain futures and options in simpler terms. Futures are like a contract that allows you to buy or sell a specific asset at a set price on a particular date in the future. On the other hand, options give you the right, but not the obligation, to buy or sell an asset at a predetermined price on a specific date. This is the main difference between futures and options.
Let’s use an example to help you understand better. Imagine you believe that the price of shares in ABC Corp, which is currently Rs 100, will increase. You want to take advantage of this opportunity to make some money. So, you decide to buy 1,000 futures contracts of ABC Corp at a price called the “strike price” of Rs 100. When the price of ABC Corp rises to Rs 150, you can exercise your right and sell your futures at Rs 100 each, making a profit of 50×1000, which is Rs 50,000. However, let’s say you made a wrong prediction and the prices move in the opposite direction, causing the ABC Corp share price to drop to Rs 50. In that case, you would have incurred a loss of Rs 50,000.
In summary, futures and options provide opportunities for buying or selling assets at predetermined prices on specific dates. They can lead to profits or losses depending on how the prices of the underlying assets move.
Let me simplify the difference between options and futures for you. With options, you have the right, but not the obligation, to buy or sell an asset. If you had bought options on ABC Corp instead of futures, you could have chosen to exercise your right and sell the options at Rs 150, making a profit of Rs 50,000, just like with futures. However, if the share price dropped to Rs 50, you would have the choice of not exercising your right, which means you can avoid the loss of Rs 50,000. The only loss you would incur is the premium you paid to buy the contract from the seller.
So, the main difference is that options give you more flexibility compared to futures.
In the stock market, you can find futures and options for indices and certain stocks. Not all securities have these derivatives available, but there is a specified list of around 200 stocks that offer them. When trading futures and options, you have to deal with lots rather than trading single shares. The size of these lots varies from share to share and is determined by the stock exchange. Futures contracts are available for different time periods, such as one, two, or three months.
Types of Options
When it comes to futures contracts, there is only one main type. However, when dealing with options contracts, you have more options to choose from. There are two types available:
Call Option: This gives you the right to buy an asset at a specific price at a fixed date.
Put Option : This gives you the right to sell an asset at a fixed price at a future date.
Call and put options are used in different circumstances. A call option is typically used when there is an expectation of price increase. On the other hand, a put option is commonly selected when there is an anticipation of price decline.
Margins and Premiums
When comparing futures and options, it’s crucial to consider margins and premiums. When entering into a futures contract, you are required to pay a margin, whereas buying options involves paying a premium.
Margin is the payment you make to your broker when purchasing futures. The margin amount varies depending on the asset and is typically a percentage of your total transactions in futures. This margin serves as a safeguard for the broker against any potential losses you might incur during futures trading.
Both margins and premiums can be used for leverage, which means you can engage in larger transaction volumes, multiplying the amount paid to the broker or writer. Let’s illustrate this with an example. Suppose you want to buy futures worth Rs 1 crore. If the margin is set at 10 percent, you only need to pay Rs 10 lakh to your broker. By paying just Rs 10 lakh, you gain the ability to enter into transactions worth Rs 1 crore. This increased exposure enhances your potential for making profits.
Let’s explore the advantages of futures compared to buying stocks. If stock prices increase by 10 percent, investing in futures with Rs 10 lakh would yield a profit of Rs 10 lakh. In contrast, if you directly invested Rs 10 lakh in stocks, you would only earn Rs 1 lakh. However, it’s important to note that futures also come with higher risks. If prices decrease by 10 percent, your futures investment would suffer a loss of Rs 10 lakh. On the other hand, if you had invested in stocks, the losses would only amount to Rs 1 lakh.
In the event of a price drop, you may receive a margin call, which requires you to deposit more funds to meet the margin requirements. This is because futures gains or losses are calculated daily through a process called marking-to-market. Any changes in the value of the futures, whether positive or negative, are reflected in the futures holder’s account at the end of each trading day. If you fail to fulfill the margin call, the broker has the right to sell your position, which can result in significant losses.
In the case of options, the risks are considerably lower since you have the choice of not exercising the contract when prices are not favorable. In this scenario, the only loss you would incur is the premium you paid to acquire the options contract. Therefore, when comparing futures and options trading, it can be said that options involve less risk.
When it comes to options, the buyer’s risk is limited, but the seller’s risk is unlimited. However, the seller (also known as the writer) does have the option to close the transaction by buying an identical options contract. Keep in mind that the writer will have to pay a higher premium for this, as the options contract would be considered “in-the-money.” This means that the holder of the options would make a profit if they were to sell them at that moment. On the other hand, for the writer, the options would be considered “out-of-the-money,” which means they would stand to lose if the contract is exercised. It is generally recommended for experienced individuals to engage in options writing, as they can assess the level of risk involved and avoid significant losses.
There are two methods for settling futures and options. The first is to settle them on the expiration date, either by physically delivering the shares or by settling in cash. The second method is to settle them before the expiration date by closing the transaction. For instance, you can close a futures contract by purchasing another identical contract. This can also be done for options contracts.
Also Read: How to Invest In Stock Market
After considering the advantages and disadvantages of options and futures, it’s important to make your choices based on your risk tolerance and investment goals. As we discussed earlier, futures involve higher risk because you are exposed to any price changes, which can lead to significant losses. On the other hand, in options trading, if prices move unfavorably, your losses are limited to the premium you paid for the contract. However, it’s worth noting that the chances of making profits are generally higher in futures compared to options. It is common for most options contracts to expire without any profits being realized.
Frequently Asked Questions
Which has more leverage options or futures?
Futures contracts are interchangeable, which means they are fungible. One advantage of trading futures compared to options is the ability to utilize more leverage. Furthermore, futures markets tend to have higher liquidity, resulting in relatively narrow spreads between buying and selling prices.
Are futures cheaper than options?
Futures contracts are typically traded in large volumes, but they only require a small upfront payment or margin. In contrast, buyers of options contracts must pay a premium to the writer, which is determined based on the current price of the underlying asset and traders’ expectations of future market conditions. Generally, futures contracts are less expensive than options, partly because they are not as volatile. The margin requirement for futures typically ranges between 3 and 12 percent of the total trade volume.
Which is more profitable, futures, or options?
Futures and options, despite both being derivatives, have distinct characteristics. Futures are relatively easier to comprehend as they offer a linear pay-off structure, whereas options have a non-linear pay-off, leading to various possible outcomes. There may be situations where buying options instead of futures is more advantageous, but before executing a trade, it is crucial to develop an F&O strategy based on a thorough analysis of the underlying asset.
Are futures riskier than options?
Both futures and options trading carry risks. Options contracts tend to lose value quickly due to high theta decay, and if they are not exercised in a timely manner, they can result in a complete loss of investment. However, futures trading is considered riskier for individual investors.
A significant distinction between futures and options lies in managing the margin requirement. Depending on the movement of the underlying stock price, either party involved may need to deposit additional funds into the trading account to meet daily trading obligations. This can increase the overall cost of trading futures, which can be a challenge for small investors.
What are the advantages and disadvantages of using an options contract rather than a futures contract?
When comparing futures contracts to options, the latter has its own set of advantages and disadvantages.
Advantages of Options:
– Options offer greater flexibility and are non-obligatory, unlike futures.
– They provide the opportunity for significant leverage without committing to the trade.
– Hedging with options allows for risk mitigation without sacrificing profit potential.
– The maximum loss for options is known upfront to the buyer, which is the premium paid.
Disadvantages of Options:
– Options trading often involves multi-leg transactions, resulting in increased overall trade costs.
– Options tend to be more volatile compared to futures.
– The risk potential for short selling options is unlimited.
– Options strategies can be complex, making them difficult for new traders to comprehend.
– As the expiration date approaches, options rapidly lose their value.
In the debate of futures vs. options, it is important to weigh these advantages and disadvantages to determine the most suitable choice for your trading approach.
Also Read: Types of Trading in Stock Market