The debate over futures and options never seems to end. The stalemate is a bone of contention even to the most experienced commodity investors and traders in the share market today. They ramble on and on about which is riskier, futures or options. In any case, it is vital to weigh your own tolerance for risk before you take any stance in the perennial debate. Furthermore, once you know what futures and options exactly entail, the risks of one over the other will become apparent.
Options - A Brief Explanation
An option is represented by a contract between a purchaser and a seller, giving its owner a right (but no obligation) to purchase or sell an asset at an agreed-upon price in a specific period. Options are contracts and cogs in larger groups of financial instruments known as derivatives. They are available on financial products such as indices, equities, and ETFs.
In the share market today, the value of options are derived from underlying securities, like stocks, for instance. When trading stocks, you are merely exchanging ownership within a company that is publicly traded. Contrastingly, options contracts permit you to trade the obligation/potential to buy or sell any underlying stock. If you own an option, you are not guaranteed ownership of an underlying asset. Moreover, it does not entitle you to get any dividends.
Futures - Briefly Explained
Futures are also derivative contracts/ agreements to purchase or sell specific securities or commodities assets at a fixed future date. In futures contracts, the purchaser and the seller strike deals with relation to prices, quantities and future deliveries dates in advance.
In any futures contract, you are allowed 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 sold at higher prices.
Futures, Options and Risks, at a Glance
If you are engaged in online trading activity, you may know certain things about the markets. If you trade and invest in stocks, for example, you would know that you have to open a demat account, for example. In the same way, if you know something about futures and options, you would know that they are derivatives. They are also instruments of leverage, and so, riskier than stock trading. Both futures and options derive their value out of the underlying asset that is traded in. The shifts in price of the underlying asset decide the profit or the loss on contracts of futures and options.
In the share market today, there is enough risk to deal with in the equity markets. Where futures and options are concerned, your level of tolerance of risk may be a contributing variable, but it's a given that futures are more risky than options. Even slight shifts that take place in the price of an underlying asset affect trading, more than that while trading in options. While both have the same degree of leverage and capital committed, volatility makes futures the riskier of the two. You must understand that leverage can be akin to a “double-edged sword”. You can gain money quickly, and lose it in the blink of an eye. As far as futures go, you can make profits fast and lose them in an instant, relative to options trading.
More Risks with Futures
With options, while you are involved in online trading, you may purchase put or call options. Your maximum amount of risk is limited to the money you have invested in the options. You may suffer some misfortune in case your prediction is completely off the mark, and your options are worthless by the time your contract expires, but you will lose out on just your initial investment.
Contrastingly, with futures contracts, you are subjected to unrestricted liability. You will have no choice but to compensate for your daily losses by topping up more capital, by making a margin call. The loss you incur daily may force you to continue till the underlying asset carries on sailing against the wind. You could even sink into debt in the event you choose to direct most of your investment into futures contracts, lacking funds to make up for your margin calls. Does all this sound too risky and prompt you to invest in an upcoming IPO instead? You needn’t worry. Technically, futures in themselves are not riskier as such — it is the ability of futures to employ a higher leverage degree that has a role in magnifying both profits and risks. You can easily purchase stocks on a margin, getting 5:1 leverage. Futures may give you 25:1, 50:1 or even higher. Therefore, the slightest moves may result in immense profits or massive losses, depending on the investment.
Some Considerations
In the arena of online trading, if traders had to select 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 wiser choice, especially if you take advantage of the spread strategies that options give you. Your odds of being successful can be boosted with bull call spreads, and bear put spreads if you intend to hold on for trades in the long term. The issues with futures being more risky is that they involve a greater degree of leverage, and a smaller amount of cash controlling assets having 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/sell a particular position.
Evaluate Your Risk
When you open your demat account for trading in equities, you would have likely evaluated your potential for risk, and your own personality as a risk taker or a risk-averse trader. If you are completely apathetic to risk, but yet wish to invest in equity, you may consider any upcoming IPO to invest in. In case you wish to take a chance on futures and options, it would be less risky to begin your trades in options contracts. The potential to lose more in futures may put you off both futures and options, but options may give you a good opportunity to start your trading in this area of investing.
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