Futures and Options (F&O) are derivative contracts. As the name suggests, they don’t command any value of their own, and rather, they derive their value based on the movement of underlying assets—stocks, bonds, currencies, commodities, etc.
For more information, you can refer to our articles on the basics of F&O.
Since you have an option of choosing between futures and options contracts on any asset, say stocks, it’s quite natural to have some confusion while selecting the right alternative. This article aims to clear the air and highlight the difference between futures and options.
Options trading has become immensely popular in India over the last few years, specifically during post-pandemic times. Lower capital requirement (as compared to that in futures), growth of the broking industry beyond Tier 3 towns (80% of F&O traders come from cities beyond the Tier-1,2,3 cities) and proliferation of digital content on F&O have options in the limelight.
|Futures are simple and straightforward to understand
|Options are complex
|Future prices derive their values primarily from the spot price adjusted for the interest rate on risk-free securities (viz. interest on treasury bills) and dividends.
|The price of an option primarily fluctuates based on two factors—change in the price of the underlying asset and anticipated volatility before expiry—i.e. based on Intrinsic value and time value respectively.
Therefore, it’s important to note that any option nearing its expiry can quickly lose the “time value” component of the price.
Owing to this, option trades must pay close attention to the moneyness of the option (i.e. whether In-The-Money or Out-Of-The-Money.)Out-of-the-money contracts can lose their time value rather quickly than In-The-Money Options as the expiry nears.
It’s noteworthy that, the change in the price may not be good enough for your options position to fetch you profits since the time decay can play a spoilsport.
|Futures are obligatory
|Options give you a right without any binding if you are a buyer
|Futures are riskier than options
|Options are less risky as compared to futures
|Both buyers and sellers of futures can incur heavy losses
|Option buyers are exposed to a limited loss. However, option writers can incur heavy losses
|Trading in futures requires higher initial investment as compared to options
|Option buyers can initiate a position with a relatively small amount of capital
Source: Paper published by the Department of Economic and Policy Analysis and SEBI, demonstrating comparative profit and loss analysis amongst F&O traders (FY22 data considered).
You might make bigger losses on futures but they are relatively easy to understand. Having a directional view (price view) is crucial. Capital requirements are high in futures.
On the other hand, options come as a benign alternative to futures but they too are risky.
In theory, the biggest difference between futures and options is how they derive their underlying value. More often than not, naïve investors undermine the role of time decay on their positions in options. Moreover, they also fail to acknowledge the heavy cost incurrence on account of frequent trading coupled with a higher loss percentage.
In other words, whether you trade in futures or options; your success primarily depends on