Futures vs options: which is better?
In the past few years, futures and options have become very popular with investors, especially in the stock market. This is because of the many advantages that they offer – lower risk, leverage, and high liquidity.
Futures and options are a type of derivative, which is an instrument whose value derives from the value of an underlying asset. There are many types of assets in which derivatives are available, like stocks, indices, currency, gold, silver, wheat, cotton, petroleum, etc. In short, any financial instrument or commodity that can be sold or bought can have a derivative.
Futures and options are used for two purposes – hedging and speculation. Prices can be volatile, and can cause losses for producers, traders and investors. So, these derivatives can come in handy to hedge against such volatility. Speculators use derivatives to cash in on price movements. If they can predict price movements accurately, they can make money through such derivatives.
Difference between futures and options
Futures are a contract that the holder the right to buy or sell a certain asset at a specific price on a specified future date. Options give the right, but not the obligation, to buy or sell a certain asset at a specific price on a specified date. This is the main difference between futures and options.
An illustration would help you figure it out. First, let’s look at futures. Suppose you think that the share price of ABC Corp, currently at Rs 100, is going to go up. You want to use the opportunity to make some money. So, you buy 1,000 futures contracts of ABC Corp at a price (`strike price’) of Rs 100. When the price of ABC Corp goes up to Rs 150, you will be able to exercise your right, and sell your futures at Rs 100 each and make a profit of 50×1000, or Rs 50,000. Let’s assume that you got it wrong, and prices move in the opposite direction, and ABC Corp share prices fall to Rs 50. In that case, you would have made a loss of Rs 50,000!
Remember that options give you the right, but not the obligation, to buy or sell. If you have bought the same amount of options on ABC Corp, you would have been able to exercise your right to sell options at Rs 150, and make a profit of Rs 50,000, just like the futures contract. However, if the share price fell to Rs 50, you would have the choice of not exercising your right, thus avoiding a loss of Rs 50,000. The only loss you will incur is the premium you would have paid to buy the contract from the seller (called `writer’).
So, this should help you understand the difference between futures and options.
In the stock market, futures and options are available for indices, and stocks. However, these derivatives are not available for all securities, but only for a specified list of around 200 stocks. Futures and options are available in lots, so you cannot trade in a single share. The stock exchange determines the size of the lots, which differ from share to share. Futures contracts are available for periods of one, two, and three months.
Types of options
As far as futures contracts go, there is only one primary type. However, you have more choices when it comes to options contracts. There are two types:
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 situations. A call option is preferred when prices are expected to increase. A put option is often chosen when prices are expected to fall.
Margins and premiums
An important thing you should consider in the futures vs options debate is margins and premiums. You have to pay a margin while entering into a futures contract, and a premium while buying options.
Margin is the amount you have to pay your broker when you buy futures. Margins vary according to the asset, and are generally a percentage of the total transactions that you make in futures. This is used by the broker as protection against any losses that you may incur while making futures transactions.
Both margins, and premiums can be used for leverage, that is, make large volumes of transactions, in a multiple of the amount paid to the broker or writer. An example should help illustrate this better. Let’s say you want to purchase futures worth Rs 1 crore. If the margin is 10 percent, you only have to pay Rs 10 lakh to the broker. So by paying just Rs 10 lakh, you will be able to enter into transactions worth Rs 1 crore. This increased exposure will increase your chances of making profits.
You can see how advantageous this is when compared to buying stocks. If stock prices rise by 10 percent, you would have made Rs 10 lakh by investing in futures. On the other hand, if you had invested in stocks directly the same investment of Rs 10 lakh would have fetched you only Rs 1 lakh. However, the risks are higher for futures too. If prices fall by 10 percent, your futures investment will stand to lose Rs 10 lakh. If you had invested in stocks, the losses would have been just Rs 1 lakh.
When prices fall, you will get a margin call to deposit more money so that you meet the margin requirements. This is because gains on futures are marked-to-market every day. This means that changes in the value of the futures, whether up or down, are transferred to the account of the futures holder at the end of every trading day. If you don’t pay up the margin call, the broker can sell your position, and this could lead to huge losses for you.
As far as options go, your risks will be considerably less, since you have the choice of not exercising your contract when prices don’t go your way. In that case, the only loss will be the premium that you have paid. So while trading futures vs options, you could say options involve less risk.
In the case of options, while the buyer bears limited risk, the seller’s risk is unlimited. However, the writer does have the option of squaring off the transaction by buying an identical options contract. But the writer will have to pay a higher premium since the options contract will be in-the-money, that is, the holder of the options will make a profit if they are sold at that moment. For the writer though, the options would be out-of-the-money, that is, he will stand to lose if the contract is exercised. Generally, options writing is best done by experienced people who can gauge the amount of risk involved, and avoid getting their fingers burnt.
There are two ways of settling futures and options. One is to do it on the expiry date, either through the physical delivery of shares, or in cash. You can also do it before the expiry date by squaring off the transaction. For example, you can square off a futures contract by buying another identical contract. This can be done for options contracts as well.
We’ve seen options vs futures advantages and disadvantages. You have to make your choices, depending on your risk appetite, and investment objectives. As we have seen above, futures involve more risk since you have to bear the brunt of any changes in price. In options, in the event of unfavourable changes in price, your losses are limited to the premium that you have paid. But having said that, the chances of making money from futures are higher than in options. Most options contracts tend to expire worthlessly, that is, no profits are booked.