F&O trading is generally considered to be a big boy’s game in the stock market. FIIs, DIIs, mutual funds, HNIs, etc. are the major players in F&O trading. This is especially true for futures trading where most retail traders stay away due to high capital requirements. Retail investors often get attracted towards option trading (specifically option buying) because of the low capital requirement. However, this causes retail traders to often miss out on the advantages which futures trading has over options trading.
Before understanding the advantages of futures trading over options trading, first let’s consider the similarities between options trading and futures trading.
Similarities between futures and options
1. Both futures and options are not assets, they are financial contracts
Unlike stocks in which people invest their money for the long term, futures and options are simply financial contracts which get their value from the underlying asset (i.e. a stock or an index). Simply put, buying a Futures contract for Reliance Industries or buying a Call option for TCS doesn’t mean that you are investing in the respective stocks. F&O trading simply means that you are buying (or selling) a contract which allows you to buy (or sell) an asset in the future. Both futures and options are simply contracts and unlike stocks, they do not represent ownership of a company. Many beginners make the mistake of thinking that they are buying an option as an investment. It is simply a short-term trade which has been misunderstood as an investment!
Even though long-term investors do not need to trade futures and options, these financial contracts can act as excellent tools for hedging your portfolio. To learn more about hedging using F&O, visit this article!
2. Both futures and options expire
Since futures and options are simply financial contracts, they expire on a certain date which is called the expiry day. For monthly options and futures, the expiry day is last Thursday of the month & for weekly options, the expiry day occurs on the respective week’s Thursday. Both futures and options require the trader to plan their exit at or before the expiry. Another strategy which many traders use (mainly in futures) is to roll-over their position to the next month. Therefore, the trading strategy for both futures and options needs to place a special emphasis on the day of expiry.
3. Both futures and options trading can provide gains (or losses) much higher than stocks
F&O trading has an advantage over stocks because they can provide much higher gains (or losses) compared to stock trading. This is because of the way these financial contracts work. Futures trading allows a trader to take much bigger positions than stock trading simply because leverage is involved in futures trading. Imagine being able to have a position of Rs. 10 Lakh even though your entire capital is only Rs. 2 Lakh! This is possible with futures trading, not stock trading.
Options, on the other hand, only require a buyer to pay the premium of the stocks (and not the full price of the stock) making it very volatile and highly attractive to traders. Options, as the name suggests only provides an ‘option’ to the buyer which they may or may not choose to exercise. To learn more about how options work, visit this article!
4. Both futures and options can be bought or sold only in lot sizes
Unlike stocks, both futures and options can be bought only in lot sizes. Every single stock in NSE in which F&O is allowed, has a lot size e.g. Reliance Industries has a lot size of 250, TCS has a lot size of 150, HDFC has a lot size of 300, etc. A trader has a freedom of buying or selling stocks in any quantity which he/she wants e.g. buying or selling 33 Reliance Industries or 11 TCS or 43 HDFC. However, in futures and options trading, a trader cannot buy 33 Reliance or 11 TCS or 43 HDFC. A trader is forced to buy stocks in the multiple of lot size of the stock.
5. Both futures and options can be bought or sold for indexes
Futures and options trading is available for indexes such as Nifty, Bank Nifty, etc. Even though stock trading is not possible for indexes, F&O trading is not only possible for indexes but is one of the most liquid trading in the Indian stock market. Suppose you are bullish on the entire Nifty 50 index instead of a specific stock, it is possible to trade the index with the help of futures and options.
6. Income from F&O is considered business income
Both futures and options trading are considered as speculative investments because they are not long term investments. Both futures and options are not an investment, rather they are financial contracts which get traded for the sole purpose of making money.. Therefore, income from both futures and options trading is considered as business income and gets taxed under the highest tax bracket (30% at the time of writing).
Even though there are a lot of similarities between futures and options trading, there are a few differences between them as well. Options trading has some weaknesses which futures trading doesn’t have!
Why Futures trading is better than Options trading?
1. Option trading highly favours sellers over buyers
Options are notorious in favouring sellers over buyers. The odds are always stacked against an option buyer because not only do the option buyers have to predict the direction of the stock, he/she also has to predict the speed of the stock. E.g. an option buyer has to buy a Put option only if he/she predicts that the stock will plummet fast! Even if the option buyer is right after the fall in the stock but the price fall occurs slowly, there is a high chance that the option buyer will lose money! This discrepancy between the winning odds of options buyers vs sellers is explained in much more detail in the article – Why do most option buyers lose money? New traders get enticed by option buying because of the potential of unlimited profits and limited losses but they do not realize that the chances to lose are also very high!
2. Options are much more volatile (and much less predictable) than futures trading
Options are generally much less predictable when compared to futures. Let’s consider an example of an option. The current price of Nifty 50 is 17470 (at the time of writing). Suppose you buy a Call option for 1 lot of Nifty 50 with the strike price of 18000 which expires at the end of April 2022 by paying a premium of Rs. 25. This means that you, as an option holder, have an ‘option’ to buy 1 lot of Nifty 50 anytime before the day of the expiry for 18000 & sell it at the current market price. You can make a profit in this Call option only if the price of Nifty 50 index goes over 18025 (18000 is the strike price & 25 is premium which you have paid). However, this premium which you have paid (of Rs. 25) is highly subjective. The option is trading at Rs. 25 only because people think that Nifty 50 has a small chance of reaching this target which is very far away from the current price.
But it is completely possible that even though the index price rises, the option might still go down if the volatility reduces. The price of the option is dependent on the stock/index price, India VIX (which measured volatility of the index), days left for the expiry, Put/Call ratio, etc. This makes option trading much more complicated because many parameters are involved!
On the other hand, futures trading works pretty much the same way as stock trading where the price of the futures is very closely related to the price of stock/index. There is even a facility to rollover your position to the next month with a small charge. It is a more straightforward way of trading with less parameters involved.
3. Time decay in options trading
Time decay is the biggest issue in options trading. Every option buyer needs to understand that as soon as you buy an option, time is ticking against you. For every minute the underlying stock doesn’t move in your expected direction, you slowly lose money. This decay in option price due to the passage of time is the reason why option trading requires exact timing of the change in price of stock. The exact timing of the rise or fall of stock is something which is not in control of retail investors. However, it is something which can be influenced by big players. Big players (such as FIIs, DIIs, mutual funds) have enough capital to move the market in the direction which favours their F&O position. This is exactly why the behaviour of a stock is highly unpredictable on the day of the expiry. To learn more about this, visit the article – Index management!
Options trading forces new traders who have lower capital to stick to option buying because option selling requires a lot of capital. This directly forces new traders to only buy options (and never sell options) in which the trader continuously loses their money due to time decay. A lot of skill is required for a trader to pinpoint the timing of a price action of the stock. Inability to do so will simply lead to erosion of trading capital.
This issue of time decay is not present in futures trading. If the stock stays range bound for a week, then the futures for that stock will also remain range bound for that week (option buyers would lose tons of money during that week).
4. Options trading has lower liquidity than futures trading
Options trading typically has lower liquidity when compared to futures trading. There are many instances in which Calls & Put options which are Out of the money options (OTM) lose their value quickly because of low liquidity. Less liquidity means that it is difficult for a trader to exit his/her position when required. Since the entire premise of trading is based on a quick entry and exit on your positions, low liquidity is a massive disadvantage for a trader. To learn more about why liquidity is important for trading, visit this article!
5. Small movements against your expected direction leads to huge losses
Since options are always under a time decay, even a small movement against your expected direction can lead to huge losses. Let’s suppose that you are bullish on TCS & you decide to buy a Call option for TCS. If the stock price falls even by a small amount, there is a very high probability that the option premium will fall very rapidly. Even a 1% drop in the stock price is sometimes enough to cause a 10% fall in OTM options! Option buying only works if the price of the stock moves in your expected direction as soon as you buy the option. Even small opposite movements will simply add to the decay in the option premium.
6. Difficult to define a stop-loss in options trading
One of the most important tools for a stock market trader is the usage of stop-loss. Stop-loss protects a trader by limiting his/her losses which is crucial for any successful trader. To learn more about the necessity of stop-loss, visit this article! Using a stop-loss in options trading can be much more difficult than futures (or stocks) trading. The price of the option is not only dependent on the price of the asset (stock/index) but it also depends on many other factors. Since technical analysis can only provide a stop-loss level i.e. a price of the asset in which the trader should exit his/her position, it becomes very difficult to exit the position on a stop-loss.
Let’s suppose that you buy a TCS Call option with the strike price of Rs. 4000 which expires at the end of April, 2022. The current price of TCS is Rs. 3759 and suppose you find out the stop-loss to be Rs. 3700. It is possible that your entire trading capital will be lost even if the stock never falls to Rs. 3700. If the TCS stock stays under Rs. 4000 for the entire month of April, you will lose everything without even triggering your stop-loss!
7. You can lose in options trading money even when you’re right
Options trading (specifically option buying) requires a trader to not only be right about the direction of the stock, but also the speed of the price movement. If you buy an OTM option expecting the price to quickly reach a certain level, you can lose money even if you are right. It is completely possible for a stock to get stuck in a range or for the stock to give a false breakout. Even if the stock gives a true breakout, it can still be a slower breakout than what you expected causing the price to never reach your strike price. In all these scenarios, the option buyer will lose money, even though his/her analysis was accurate!
In this example, the price of the Call option for Tatasteel stock fell, even though the stock price rose!
Does futures trading have any disadvantages?
The biggest disadvantage of Futures trading is the requirement of high capital and usage of leverage.
Futures trading cannot be done with a low capital. In fact, even the ability to afford one lot of futures is not sufficient capital for investment. If you are buying or selling 1 lot of an index or a stock in futures trading, it means that you are still borrowing around 80-85% of the remaining capital from your broker. A move of 20-25% in the index or stock which is opposite to your anticipated direction can easily wipe your entire capital. A futures trader should have sufficient capital left-over after taking up a futures trade because this capital can act as a protection against getting completely wiped. In case of a reversal, this capital will also allow a futures trader to take up an opposite position in the market quickly.
Low capital in futures trading can force a trader towards a lack of diversification. If your entire capital is sufficient for a single lot, it simply means that you are putting all your eggs in one basket. Suppose you buy one lot of Nifty futures & the market tanks then next day, you will end up losing all your capital. And rest assured, there will be days in which the stock market will move violently in the direction opposite to your anticipated direction, so going all in is never a good option!
A good understanding of leverage is required for any futures trader because leverage works both positively and negatively. A well positioned futures trader will make higher profits than a well positioned stock trader, but a poorly positioned futures trader will lose more money than a poorly positioned options trader! Leverage can also be extremely dangerous during volatile times, so a trader needs to be fully prepared for a worst case scenario.
Futures trading example
Let’s consider an example of futures trading. Suppose you are highly bullish on Reliance Industries stock and want to take up a long position. You have a total capital of Rs. 1.5 Lakhs of the trade. You can either trade RIL stock or you can trade its future. Let’s consider both scenarios.
If you decide to trade Reliance Industries stock, you will be able to buy 57 stocks (considering a trading capital of Rs. 1.5 Lakh and an individual stock price of Rs. 2600). You buy the shares and sell it after 15 days when the price of the stock rises to Rs. 2700. You made a profit of Rs. 5,700 (Rs. 100 profit on 57 stocks) on your trading capital of Rs. 1.5 Lakh making a 3.8% return on your trading capital of Rs. 1.5 Lakh.
If you decide to trade Reliance Industries futures, you will be able to buy 1 lot which consists of 250 shares. Even though the total value of 1 lot of Reliance Industries is Rs. 6.5 Lakhs, you will be able to buy the entire lot by providing a margin of Rs. 1.5 Lakhs to your stock broker! This simply means that the stock broker is lending you Rs. 5 Lakh for your futures position. If you sell the futures contract when the stock price rises to Rs. 2700, you would have made a profit of Rs. 25,000 (Rs. 100 profit on 250 stocks)! You will be able to return the borrowed Rs. 5 Lakhs to the stock broker along with a small fee and make a 16.67% profit on your trading capital of Rs. 1.5 Lakh.
Both stock and futures trading work in the exact same way, except for the fact that leverage is involved in futures trading. Traders need to beware that this addition of leverage works in both directions (profit AND loss). If the Reliance stock’s price gets reduced to Rs. 2500 instead of rising to Rs. 2700, you will lose 16.67% capital in futures trading & 3.8% capital in stock trading. Similarly, if the Reliance Industries stock falls more than 20%, you will lose all your trading capital simply because your trading position will get automatically squared off once your trading capital gets over! This phenomena of losing your entire capital once the losses become big enough is called a margin-call!
Why should beginners avoid both futures and options trading?
Beginners should completely avoid futures and options trading because they are much more volatile compared to stock trading. Futures are more volatile due to involvement of margin which can be complicated for a new trader to understand. On the other hand, options (specifically option buying) requires very high skill of being able to predict the direction as well as the speed of the movement of stock making it completely unsuitable for new traders.
New traders should only focus on stock trading which is the simplest form of trading. This will improve the accuracy of the traders which will prepare them for F&O trading (if needed). Between futures and options, traders should generally prefer futures trading because it has a lot of advantages when compared to options trading. Also, futures trading is essentially the same as stock trading with an added spice of leverage. To learn more about a profitable trading system which is used by professional traders, visit this article!
Conclusion
Futures trading has many advantages over options trading. It is the more straightforward trading alternative which is similar to stock trading. A good stock trader can easily transition to futures trading as long as he/she understands the concept of leverage well. There are much less things to worry about in future trading such as time decay & the sellers’ advantage. However, the final decision to trade stocks, futures or options depends entirely upon the reader!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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