My friend and I were discussing the risks involved in futures and options. I prefer options because they require less money (for the buyer) to purchase an options contract compared to a futures contract. Conversely, my friend typically trades futures contracts and dislikes trading options, particularly due to the theta decay, despite having a large corpus of trading capital. The day ended, but our discussion did not. In this article, we will determine which one is riskier as both belong to derivative trading. Let’s briefly go through the concepts of Options and Futures first.
Understanding Futures and Options
A futures contract is a standardized agreement between two parties to buy or sell an underlying asset at a predetermined price on a specified future date. In any futures contract, you have the option to take either the position of a purchaser or a seller. If the price rises, buyers reap profits since they bought assets at lower prices. If the prices drop, sellers take profits since they sell at higher prices.
An option contract is a financial derivative that offers the buyer (holder) the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time frame. There are two primary types of options: call options and put options. They are widely used by investors and traders for various strategies including hedging, speculation, and income generation. The value of options is derived from underlying securities, such as stocks.
Risk in F&O
If you actively participate in trading, you might be familiar with certain market aspects. For instance, when trading and investing in stocks, you typically need to pay the full amount in the cash market. Similarly, if you possess knowledge about futures and options, you’d understand they function as derivatives. These instruments involve leverage and therefore carry higher risk compared to stock trading. Both futures and options derive their value from the underlying asset being traded. Profits or losses in futures and options contracts are determined by fluctuations in the price of the underlying asset.
What risks do individuals face exactly? Capital erosion, loss of capital, and experiencing profit and loss are inevitable aspects. However, the reduction of capital or capital erosion tends to have a much more significant psychological impact on every individual, especially when someone has less capital.
In today’s stock market, dealing with risk in equity markets presents its challenges. When it comes to futures and options, your risk tolerance plays a role, but it’s widely accepted that futures entail higher risk than options. Even slight price shifts in an underlying asset have a more pronounced impact on futures trading compared to options. Despite both involving similar leverage and committed capital, the inherent volatility makes futures the riskier choice. It’s crucial to recognize that leverage behaves like a “double-edged sword” allowing for quick gains but also rapid losses. With futures, profits can accumulate swiftly but can also vanish in an instant, more so than in options trading.
More risk with futures
In the case of buying Options, your maximum risk is limited to the money you have spent on these options. If your prediction proves completely inaccurate and your options become worthless by the contract’s expiration, you may incur a loss equivalent to your initial investment.
Contrastingly, with futures contracts, you face unlimited liability. You are obligated to cover daily losses by injecting additional capital through a margin call. Daily losses might compel you to persist in the trade even if the underlying asset moves unfavourably. If most of your investment is in futures contracts and you lack funds to meet margin calls, you might potentially accumulate debt. Does this heightened risk urge you to consider investing in an upcoming IPO instead? There’s no need for concern. Technically, futures themselves are not inherently riskier; it’s the high leverage capacity they offer that magnifies both profits and risks. While buying stocks on margin provides 5:1 leverage, futures can offer even higher leverage. Consequently, even minor price movements can lead to substantial profits or significant losses, depending on the investment.
In the arena of online trading, if traders had to choose between trading futures and trading options, the major attraction would be in the world of options. In options, you cannot lose more than your original investment. Trading in options may turn out to be a good choice, especially if you take advantage of the spread strategies that options give you. Even the odds of being successful can be boosted with bull call spreads and bear put spreads if you intend to hold onto trades in the long term.
The issues with futures being riskier are that they involve a greater degree of leverage and a smaller amount of cash-controlling assets with a greater value. What this implies is that the amount you can lose may be unlimited, exceeding your initial deposit. Furthermore, certain market considerations could also make it hard or even impossible to hedge or sell a particular position.