Futures and options are a popular segment of derivative trading and have attracted many traders for years now. The influx of new traders in futures and options trading is ever-increasing with the advanced tools for real-time trading and easy user interface. However, if you are a new trader, you may be faced with the question of which is better among the two. Well, read on to get your answers and start your trading journey.
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What are futures?
Futures are financial contracts that allow traders to buy or sell an underlying asset, such as commodities, currencies, or stock market indices, at a predetermined price on a specified future date. These contracts obligate the buyer to purchase, and the seller to sell, the underlying asset at a predetermined price on a specific future date. Futures are standardised contracts that enable traders to speculate on the price movements of the underlying asset, either betting that it will rise (going long) or fall (going short). These contracts are popular for hedging against price fluctuations and for speculative trading, Future trading can provide opportunities for potential profits but also carries risks, as they involve leverage (using small capital to hold larger positions) and can result in significant gains or losses.
What are options?
Options are financial instruments that provide traders with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) on or before a specified future date (expiration date). These contracts are widely traded on stock exchanges like the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Like futures, options are also used for various purposes like speculating price movements, hedging against potential losses and generating income through strategies like covered calls and selling outs. Furthermore, traders get flexibility in options contracts as compared to futures contracts which facilitates better risk management and involves understanding of key terms like time decay, implied volatility and more.
What are the advantages of Futures over Options?
By understanding the basic meaning of futures and options contracts above, it is clear that the basic advantage that options have over futures is the right and not the obligation to buy or sell the underlying asset. While this is a significant advantage, to a layman, futures would outright seem to be unfavourable. However, there are many advantages that make futures more suitable to some traders than options. These advantages are discussed hereunder.
Simplicity and Transparency
Futures contracts are straightforward financial agreements. They involve an obligation to buy or sell an asset at a predetermined price and date. The simplicity of futures makes them attractive, especially for individuals who are new to derivatives trading. Traders can easily understand the terms of the contract, such as the contract size, expiration date, and delivery conditions. Options, on the other hand, can be more complex. They provide the holder with the right but not the obligation to buy (call option) or sell (put option) an asset at a specified price. Options come with various terms, including strike prices, expiration dates, and different strategies like spreads and combinations. Understanding these nuances can require a deeper knowledge of financial markets.
Liquidity
The futures market is generally considered to be more liquid than the options market for a wide range of asset classes, including equity indices, commodities, and currency futures. The liquidity feature of futures ensures that traders can easily enter and exit positions at competitive prices, reducing the risk of price slippage. On the other hand, while the options market is also quite well-established, it may have lower liquidity for certain contracts, especially those with less popular underlying assets or longer maturity periods. This lower liquidity can make it more challenging for traders (especially novice traders) to execute large trades efficiently.
Cost efficiency
Trading futures is often more cost-efficient than trading options. The transaction costs associated with buying and selling futures contracts are typically lower. This affordability appeals to active traders as it allows for more frequent trading without incurring substantial expenses. Options trading can be costlier due to the premium paid to acquire the right to exercise the option. Additionally, options may have wider bid-ask spreads, leading to higher trading costs, especially for illiquid options.
No expiration Risk
Futures contracts have predefined expiration dates, and there is no expiration risk associated with them. Traders can roll over their positions to the next contract month if they wish to extend their exposure. This eliminates the risk of options expiring worthless, which can happen if the market doesn’t move favourably. Options come with expiration dates, and if the market doesn’t move in the desired direction before expiration, the option can expire worthless. This can result in a total loss of the premium paid for the option.
No concept of time decay
Futures do not suffer from time decay, which is a crucial advantage over options. Time decay erodes the value of options as they approach their expiration date. Futures prices, however, are not affected by this phenomenon. Options traders must consider the time decay concept where the value of an option diminishes as it approaches expiration. This can make it challenging to comprehend and hold options for extended periods without seeing their value erode.
Rollover convenience
Futures have the convenience of rollover their positions from one futures contract to another when the current one nears expiration. This feature allows the traders to easily shift their trading positions to the following contract month without any complexities that are often associated with options trading. Options, on the other hand, are more complicated when they get close to their expiration date. Traders have to think carefully about whether to use them, move them to another time, or close their positions, which can involve several steps and might be tricky to manage.
Are futures better than options?
The choice between futures and options hinges on individual financial goals and risk tolerance. Futures contracts are binding and carry high leverage, making them suitable for confident market predictions but also posing the risk of unlimited losses, which may deter risk-averse individuals. In contrast, options offer flexibility and limited risk, as losses are typically confined to the premium paid. They are favoured for their versatility and risk management capabilities, appealing to traders looking to hedge positions or generate income through strategies like covered calls.
Ultimately, the choice between futures and options depends on one’s trading objectives. Futures may be attractive for those seeking high-risk, high-reward opportunities and options may be a good option for those valuing flexibility and risk mitigation. However, it is important to note that both require careful market understanding and risk management.
Conclusion
Futures and options are financial instruments used in trading and investing as each offers distinct advantages and risks. The choice between the two ultimately depends on individual financial goals, risk tolerance, and market outlook, and it is crucial to educate oneself, formulate a clear trading plan, and consider expert advice to make an informed decision in the dynamic world of financial markets.
FAQs
Options are generally considered safer than futures because the potential loss in options trading is limited to the premium paid, whereas futures carry higher risk due to potential unlimited losses resulting from leverage and market movements.
Swing trading is generally considered to be good for beginners in trading as it offers short-term to medium-term trading periods and flexibility to find suitable entry and exit points.
Futures trading is generally not recommended for beginners, as it involves higher risk due to leverage and can result in substantial losses if not managed carefully.
The three primary categories of futures contracts include equity futures, index futures, and commodity futures, with other specialized types such as currency futures, interest rate futures, and VIX futures also available.
