Futures vs Options Trading – before we dwell deeper into this debate, let us first understand what each of these financial instruments implies. However, before that, it is important that you understand what does owning an equity share implies –
“Owning an Equity is like owning an ownership stake in the company. The holders of Equity shares have voting rights and have ownership say in the management and working of the company. Equity shareholders are partners in the growth and tough times of the company. They are entitled to receive dividends”
Now that you know the meaning of owning equity, let me define the basics definition of futures vs options trading:
“Futures are like a forward contract whose value is derived from the value of the underlying asset. In the case of companies, the underlying asset is equity share values and in the case of Index, the spot price of Index. The futures contract owners don’t have an ownership right on the asset they are underlined with”
“Options, as the name suggests, gives an option to the buyer, if wants to buy (Call option) or sell (Put option) on or before the expiry of the contract. He buys this right from the option seller by paying a fee (Premium) and the seller is obligated to honor his promise”
Benefits of Futures Contract
Here are a few key benefits of future contracts:
- Since Futures derive its value directly from an underlying asset, so any movement in the underlying price has equally proportionate movement in the value futures contract.
- The futures contract can be rolled over to next month contract at the same price as the expired contract expiry price.
- Futures contract do not face time decay problems as the value is direct proportional to the value of underlying and expiry does not affect its pricing.
- Liquidity is one of the most important factor in futures trading. The standing bids and offers make it easier for interested parties to exit and enter positions.
- The margin required for trading via futures haven’t changed much in years. They are changed a little bit when the market becomes volatile. So, a trader is always aware of the margin required before taking positions.
- The pricing is easier to understand as the values are based on Cost to carry model i.e., the futures price should be the same as the current spot price plus the cost of carry.
Benefits of Options Contract
Here are a few key benefits of Options contracts:
- As the name would suggest, the Options contract gives the right to option buyer to exercise his contract if he wishes to. If the Spot price doesn’t go in favor of the buyer of the contract he does not have to exercise his right, he stands to lose just the premium.
- One time premium is the only fee that option buyer has to pay to ride the momentum of underlying price and be a part of a bigger game.
- If an option seller is of the opposite view to that of option buyer, he can just sell the option contract and pocket premium income.
- The options are less risky than equities. Say for example if a trader wants to buy 1000 shares of Reliance, then at CMP (Rs 1400 per share), one has to shed out Rs 14,00,000 (fourteen lakhs). But one can express the same view by buying 2 Call option contracts (500 shares each). Say if he buys At the Money contract of 1410 CE by paying a premium of 35 per lot. Then, his total cost would be = (500*35*2)= Rs. 35000 only. So, now If option were to expire Out of Money for option buyer, he just stands to lose premium only. But, if the share price of Reliance Industries comes down to Rs. 1300, then total loss of equity shareholders will be Rs. 1,00,000 (1000*100).
- Return on investment for an option buyer is very high because the cost paid is just the premium and the potential return is unlimited.
Futures vs Options Trading: Which strategy is better?
There is no right answer as to which instrument is better. It all depends on one’s risk appetite, and view on the market. However, here are a few key points to compare which strategy is better:
- Options are optional financial derivatives whereas Futures are compulsory derivatives instruments.
- The seller of an option is exposed to unlimited risk but the buyer’s risk is limited to the premium paid. But in the case of Futures, both buyer and seller have equal risk associated with their trades.
- The options although they can be rolled but have a different premium for different expiry, but in case of futures, they are rolled over at the same price in the next contract.
For example, if someone has bought the Future contract of XYZ Company at Rs. 110 and if upon expiry the price of XYZ is Rs. 105, he can simply roll over the position to next expiry at Rs. 105 and his entry price is not changed. But in case of Option, if an investor bought 110 call options of XYZ Company by paying a premium of Rs. 5 and it expires worthless, then he again has to buy next expiry contract by paying a fresh premium (Say Rs. 7). So to reach the breakeven, the spot price of XYZ Company has to go above Rs. 122(110+5+7).
From the discussion above it is clear that both financial derivatives instruments, Futures vs Options Trading, have their own advantages and disadvantages. One has to be rational, bias-free, use his/her judgment, and have proper risk management to survive long in the trading World. Happy Investing and Happy Money making.
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!