Stock Market Basics

Difference between futures and options trading

Derivative trading corners a major part of the trading volume on the stock exchanges. The daily derivatives trading has grown exponentially since the advancements in technology. Though the volume keeps changing on a daily basis, approximately more than 1 lakh crore of trading in derivatives is a common occurrence.

During expiry week, the total derivative trading can be as high as 4 lakh crore. This denotes the popularity of derivative trading in India. Though derivative trading involves high-risk, the expert traders use the high leverage and profit from it.

Derivative trading involves futures and options trading.

Futures trading

Though futures trading started as a form of hedge for the farmers, it has slowly gained popularity and is used in all instruments like commodity trading, forex markets, and the stock markets. The Indian futures market is a buoyant market with maximum volume coming from it. There are many traders like Rakesh Jhunjhunwalawho have used the futures market to successfully increase their account size.

Advantages of futures trading

  1. The leverage in futures trading is the main tool used by the experienced traders to increase their profits. A trader who buys delivery of 500 shares of Reliance industries quoting at Rs.1000.00 will have to shell out Rs.5,00,000.00 to buy the stock.

However, the same quantity of 500 shares of Reliance can be held by a futures trader by keeping Rs. 62,000.00 in the account as margin money.

  1. If the trader is able to buy at the right time, his profits can multiply by buying a large quantity of stocks in the futures market by keeping the required margin money as compared to the cash markets.
  2. An experienced futures trader can earn both in the bull and the bear phase of the markets.
  3. Futures trading can be utilised to hedge the investment positions, thereby, the investors are able to hold on to their long-term core portfolios without suffering large losses.

Disadvantages of futures trading

  1. During market crashes, if the futures trader is leveraged, margin calls get triggered, which can lead to large losses. The market crash in 2007 is an example when many leveraged traders went bankrupt.
  2. As only the near-term futures contracts are active, long-term investment positions are difficult to hold. Rolling over every month into a fresh near-term contract can be costly due to a high cost of carry on new contracts.
  3. No dividends are awarded to the futures traders.
  4. As a futures trader, you don’t own an asset, unlike in equity trading, where you are a part owner of the company and stand to benefit as a shareholder from the good performance of the company.
  5. There are only a limited number of stocks, which are traded in the F&O segment. Concentrating only on the F&O stocks will limit the opportunities because there are a number of stocks outside the derivatives segment, which offer good opportunities to the trader.
  6. The lot sizes in futures trading currently have a value of Rs.5,00,000.00, which can be a limiting factor to the small investor. Unlike the cash markets, there is no option to buy smaller quantities as the minimum lot sizes are fixed by the exchanges.
  7. No trader should enter the futures markets without having enough experience and proper risk management in place.

Options trading

Options trading is comparatively less risky than futures trading, however, you should have a clear understanding of options before you try your hand at it. We have covered the topic in detail for the newcomers, which will give you a fair idea about options.

Advantages of options

  1. Options offer equal leverage as futures trading, at a much lesser investment. Continuing with the Reliance example, one can buy the deep in the money Reliance option at around Rs. 30,000.00, which will offer the same returns as a futures position.

Compared to the cash and futures markets, options markets require the least investment.

  1. The risk is limited in options trading, the maximum one can lose is the amount one pays as a premium to own the contract.
  2. In strong bull and bear markets, the options trader earns a handsome return by taking a small risk.
  3. In a range bound market, the investors earn a steady flow of income by selling calls and puts against the underlying stock position they hold. By doing so, they hold the asset, earn dividends on it and profit from the decay in premium of the calls and puts.
  4. There are numerous strategies that can be formulated by the options trader, which can be suitable for all occasions. There are strategies for all types of markets and depending on the market conditions, the trader can place the trades.

Disadvantages of options trading

  1. Options trading is complicated, there are various factors, which affect the premium pricing. Many top options traders use complicated mathematical models to determine whether the option is overpriced or under-priced. Such facility is not available to the retail trader.
  2. Most options expire worthless and the premium is pocketed by the option sellers. Most retail traders buy options, whereas most institutional traders sell options.
  3. In order to profit from the options market, both the direction and timing has to be perfect due to time decay associated with the options.
  4. Many stock options are illiquid, the trader stands to lose a large amount of money in both buying and selling the options due to the difference in the bid and the ask price.
  5. Only near month options are liquid, thereby one cannot take a long-term view while trading in options.
  6. Nearing expiry, options lose their premium at a very fast pace. Hence, buying options without proper analysis can lead to large losses.

Conclusion

The stock markets offer a myriad of opportunities to the new entrant. But without proper knowledge, the newbie tries his hand at everything, on the advice of others and loses a large amount of money. We have tried to throw light on both the positives and negatives of all forms of trading options available in the Indian stock markets. We feel the trader should follow the below-mentioned trajectory on entering the markets.

  1. The first step should be long-term delivery based investing. The next step should be trading in short-term delivery based buying. Once the trader completes the first two steps, he can move on to the next steps.
  2. Though futures trading requires only a small margin amount to control large value of shares, the traders should not attempt to enter futures trading unless the traders are adequately funded. Trading large value of shares without having adequate money in the account can lead to margin calls and squaring of positions by the broker.
  3. As options require both timing and direction to be correct, the traders should try it only after they have been successful in trading futures.
  4. Traders can attempt intraday trading in futures or options, once they are successful in intraday trading in the cash markets.
  5. Though with experience, traders can branch out into different forms of trading, the traders will be better off if they stick to the one, which earns them the maximum profit. If you are good at day trading like Marty Schwartz, you should stick to it. If you are successful at investing, then better stick to it, similar to how Warren Buffet does.
  6. Every trader is unique, the trader should work to find his niche, which can provide him with superior results in the long run.

Tags: futures trading, options trading

Comments

Name
Email Id (Will not publish on blog)
Comment

ajay Posted on 16,Jun,16

good posting