In the world of trading, those who dabble in derivatives often find themselves at a crossroads, faced with a dilemma: Should they use options or futures when trading breakouts? Let’s break it down in simpler terms.
Capture the Gains
Most traders go after momentum stocks, which means they buy stocks that decisively break out from major resistance levels. But what if you want to trade derivatives to ride these price breakouts? In this blog, we’ll explain why futures might be a better choice than options for such trades.
Why Choose Futures?
When you’re in a momentum trade, your goal is to seize those swift price movements in the underlying asset. If you’re into derivatives, futures should be on your radar. Why? Because futures closely mirror the underlying asset’s movements. For example, if the underlying asset gains 25 points during the life of the futures contract, the futures price is likely to follow suit with a 25-point increase.
However, keep in mind that differences can emerge between the underlying and its futures price, especially when the company announces corporate actions like cash dividends or bonus shares. This factor is crucial to consider when trading breakouts are triggered by surprise corporate actions.
It’s also worth noting that the futures price tends to converge with the spot price at expiration. So, if you initiate a long position on a price breakout and the futures price is initially two points higher than the spot price, those two points could be lost if you hold onto the futures position until expiration. Thus, it’s often a better strategy to cash in your profits on a futures position before it expires.
Options: A Different Story
On the other hand, options don’t move in lockstep with the underlying asset. An option’s price consists of intrinsic value and time value. While the intrinsic value of the option moves in sync with the underlying asset, the time value of the option decreases daily and eventually becomes zero at option expiry. This has significant implications for your trading strategy.
Imagine you buy an at-the-money (ATM) call option on an underlying asset that has just broken out of a major resistance level. Suppose you paid 35 points (representing time value) for the option, and a week later, the underlying asset surges by 100 points. The intrinsic value of the call option will increase by 100 points, but the time value could dwindle (from the initial 35 points you paid). As a result, the option won’t capture the full gains from the underlying price movement.
Now, consider that if the underlying continues its rapid ascent after the breakout, the option may not lose much time value. However, predicting precisely when your price target will be reached using technical analysis isn’t foolproof. The issue is that relying on options for breakout trades might lead to lower profits if the stock moves slowly after the breakout or takes a breather before resuming its upward trend. Plus, deciding whether to enter the current series option contract or the next series contract in the penultimate week of expiry can be quite a headache.
An Alternative for Options Traders
For those determined to trade options for price breakouts, consider setting up a bull call spread. This involves going long on an ATM call or an immediate out-of-the-money (OTM) call if it shows significant changes in open interest. Simultaneously, you should short an OTM call that’s one strike above the resistance level for the underlying asset. This call spread helps offset the loss due to time decay on the long call because you’ll gain from time decay on the short call. The maximum profit at option expiry will be the difference between the strike prices minus the net debit to set up the spread. You can also combine a long futures position with an OTM call.
Whether you’re trading single-stock futures, index futures, or index options, it’s crucial to base your entry price, price target, and stop loss on technical analysis of the futures price. For equity options, make your trading decisions based on the underlying asset’s price charts.
In the world of breakout trading, the choice between futures and options might seem like a catch-22. However, by understanding their distinct characteristics, you can navigate this terrain with confidence and increase your chances of success.