When it comes to trading in the world of finance, you have got two options. No, I’m not talking about your choices for lunch today; I am referring to the two popular derivatives, Options and Futures, that have investors and traders buzzing.
These financial instruments might seem complex at first, but you have no reason to worry, because you are already here.
In the world of financial markets, traders and investors have various tools they can invest in and generate profits. But these two derivatives always find themselves in the spotlight of the market.
I am going to break down the basics of Futures and Options, so that you can easily trade them in the near future.
In this comprehensive guide, I’ll provide you with the understanding of options and futures, options vs futures, and help you choose the best one for your investment and trading strategy.
What is option trading?
Options trading does not put any obligation to buy or sell (call and put options), an underlying asset at a predetermined price, which is also known as strike price, within a defined time frame.
Options trading calls for an understanding of advanced strategies, and opening an options trading account entails a few extra steps than opening a standard investment account.
When you trade options on the stock market, you do not own the shares until you use the option. This feature sets apart options trading from stock trading.
When you buy a stock, you become a shareholder in the company. When you trade options, however, you simply express your desire to own the company’s shares on a specific date rather than owning them for real.
How does Options Trading work?
When an investor or trader buys or sells options, they get the right to apply for the options contract at any point of time before the expiration date. There are two types of options, Call options and Put options.
Call Options
Call option refers to buying of an asset. A trader can buy an underlying asset at a strike price within expiration date.
For example: If a trader wants to buy shares of an ABC company at a strike price of Rs. 1000 within the next two months.
At the moment the instrument’s price is Rs. 950, so even if the share price jumps above Rs. 1000 during the next two months, you can buy it for the price of Rs. 1000, and sell it immediately to earn profits.
But if the price drops below Rs. 1000, the call option does not oblige you to buy the instrument, just don’t use the contract.
Put options
Put option refers to selling of an asset. A trader can sell an underlying asset at a strike price within expiration date.
For example: If a trader wants to sell an underlying asset at the strike price of Rs.950 within the next three months.
At the moment the price of the instruments is Rs. 900 during the next three months, you can sell it for the price of Rs.900 and earn profits immediately.
But if the price increases to Rs.1000, you simply don’t use your option contract.
Options Trading Strategies
- Long call option trading strategy
- Short call option trading strategy
- Long put options trading
- Short put options trading
- Long straddle options trading strategy
- Short straddle options trading strategy
Benefits of Trading Options
Leverage
Traders only have to pay the premium amount rather than the entire transaction value when purchasing options. As a result, traders can take on high-value positions while requiring minimal funding.
Cost Effective
Using options, traders can use less capital to earn the same profit. Naturally, the return on investment is much higher than that of other investment avenues. Options have a high cost efficiency because the premium amount is a small percentage of the transaction value.
Option strategies
Another advantage of option trading is the ability to profit in both rising and falling prices. You may be unsure of the direction of the price movement but anticipate a significant change. A trader can develop a strategy that generates profits regardless of the underlying asset’s price direction by combining several options.
Flexible
Options provide more investment possibilities and are versatile tools. Options enable investors to profit not only from price movement, but also from the course of time and volatility movement.
Hedging
Options are an effective hedging tool that help to reduce the risk associated with current holdings. Traders can virtually eliminate any risk associated with a trade by combining options.
What is Futures Trading?
Futures trading puts an obligation to buy or sell an underlying asset at a predetermined price, which is also known as strike price, within a defined time frame.
Futures contracts are a true hedge investment and are best understood in terms of commodities such as corn or oil.
There are no fees for signing a futures contract, but the contract must be executed. This is the contract’s “obligation” feature.
How does Futures Trading work?
Futures contracts bind parties to purchase or sell the underlying asset at a predetermined date and time, decided at the time.
Let’s look at an example for how futures trading work:
If a trader wants to buy a commodity, and speculates on the price of crude oil, Rs.1,500 within the next two months. At the moment crude oil’s price is Rs.1600, so even if the share price jumps above Rs. 1,600 during the next two months, traders can buy it for the price of Rs. 1,500.
But if the price would have gone to Rs. 1400, then the buyer was obliged to buy it at a predetermined price only, which is Rs. 1,500, resulting in loss.
Future Trading Strategies
- Spread Trading
- Breakout Trading
- Going Long Trading
- Pullback Trading
- Order Flow Trading
Benefits of Future Trading
Leverage
The initial margin requirement for futures is usually set between 3 and 10% of the underlying contract value. With that leverage, your potential returns can be higher than the amount of money you invested.
Diversification
Futures allow you to diversify your investments in ways that stocks and ETFs cannot. They can provide you with direct market exposure to underlying commodity assets rather than secondary market products such as stocks. Furthermore, they give you access to assets that aren’t typically found in other markets.
Short Selling
Because the margin requirement for both short and long positions in futures is the same, it is possible to take a bearish stance or reverse a position without incurring additional margin demands.
Tax Benefits
When compared to other short-term trading markets, futures may offer a tax advantage. This is due to the fact that profitable futures trades have a 60/40 tax structure, meaning that 40% of profits are taxed as regular income and 60% as long-term capital gains.
Difference Between Futures and Options
| Options | Futures |
| An options contract offers investors the right to buy or sell an underlying asset at a predetermined price before expiration date. | A futures contract binds the investors to buy or sell an underlying asset at a predetermined price on a specific date. |
| There is low risk; if there’s a loss the investor only has to pay the premium amount. | The level of risk in futures is very high. Not only the premium amount but also the loss. |
| No obligation on executing the contract | You are obliged to execute the contract |
| Mostly there are profits, chances of losses are less. | There is no limit to profits and losses. |
| Options are highly strategic and are used for various purposes like hedging. | Futures are primarily used for speculation and risk management. |
| Options do not require a margin account as you only pay the premium amount. | Futures require a margin account to cover the potential losses. |
| Can execute the contract before or at the expiration date. | Should execute the contract at the pre-decided date. |
Conclusion
As discussed above, we have given you the complete guide on Options Futures trading as well as the difference between the options and futures.
Whatever path you take, make sure to do your homework first, learn the fundamentals thoroughly, and even go beyond them to gain a broader understanding.
Once you have sufficient knowledge and have laid the groundwork for making informed trading decisions, open a demo account to see how things work in practice.
Do not rush into trading with real money unless you are sufficiently prepared and disciplined.
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| Disclaimer: The sole purpose of our financial articles is to provide you with educational and informative content. The content in these articles does not intend any investment, financial, legal, tax, or any other advice. It should not be used as a substitute for professional advice or assistance. |