Investors and traders in India have multiple ways to participate in the stock market beyond just buying and selling shares. Future and options trading are two popular derivative instruments that allow traders to speculate, hedge risks, and amplify profits. While both are derivatives, they have distinct characteristics, benefits, and risks.
Understanding the difference between futures and option trading is essential for making informed investment decisions. This article explores how futures and options work, their key differences, and which one is best suited for different trading strategies.
What is future and options trading?
Future and options trading involves contracts that derive their value from an underlying asset, such as stocks, commodities, indices, or currencies. These financial instruments allow traders to buy or sell assets at a predetermined price on a future date, helping them hedge against price fluctuations or speculate on market movements.
Futures trading
A futures contract is an agreement between two parties to buy or sell an asset at a specific price on a specified date in the future. It is a binding obligation, meaning both the buyer and seller must fulfil the contract upon expiry.
Options trading
Options are derivative contracts that give the buyer the right, but not the obligation, to buy or sell an asset at a fixed price before or on the expiration date. Unlike futures, options allow traders to back out of the contract by forfeiting the premium paid.
Key differences between futures and options
While both futures and options fall under derivatives trading, they differ significantly in terms of risk, pricing, and obligation.
Obligation to buy or sell
- Futures – The buyer and seller are legally bound to execute the trade at the agreed-upon price on expiry.
- Options – The buyer has the choice to exercise the contract but is not obligated to do so. The seller, however, must comply if the buyer decides to exercise the option.
Upfront cost
- Futures – Traders do not pay a premium upfront but need to maintain a margin amount, which is adjusted daily based on market movements.
- Options – Buyers pay a premium to enter a contract, which is the maximum loss they can incur. Sellers receive the premium but bear unlimited risk.
Risk and reward potential
- Futures – Since it is an obligation, futures trading carries high risk but also offers unlimited profit potential.
- Options – Buyers have limited risk (the premium paid) but unlimited profit potential, while sellers have high risk with limited reward.
Market movement impact
- Futures – Prices move in direct correlation with the underlying asset, making profits or losses immediate.
- Options – Prices are influenced by multiple factors, including the underlying asset’s price, time decay, volatility, and strike price.
Expiry and settlement
- Futures – The contract must be settled on the expiry date either through cash settlement or delivery of the asset.
- Options – The contract can be exercised any time before expiry, depending on the type of option (European or American).
Which one should you choose?
The choice between futures and option trading depends on your trading objectives, risk appetite, and market outlook.
Choose futures if:
- You want a high-risk, high-reward trading approach.
- You have sufficient capital to maintain margin requirements.
- You prefer a direct correlation between the contract and the underlying asset.
- You are comfortable with daily mark-to-market adjustments.
Choose options if:
- You prefer defined risk with limited loss potential.
- You want flexibility in deciding whether to execute the contract.
- You aim to hedge existing investments without large capital requirements.
- You wish to take advantage of price movements while paying a lower upfront cost.
How to start trading in futures and options?
Traders in India can participate in future and options trading through stock exchanges like the National Stock Exchange and the Bombay Stock Exchange. Here’s how to get started:
Open a trading and demat account
To trade futures and options, you need an account with a registered stockbroker that provides derivatives trading services.
Understand margin and premium requirements
Futures trading requires maintaining a margin amount, which is adjusted daily. In options trading, buyers pay a premium, while sellers need to maintain margin requirements.
Learn about market trends and strategies
Derivative trading requires knowledge of technical analysis, market trends, and hedging strategies. Understanding concepts like implied volatility, open interest, and time decay can improve decision-making.
Monitor expiry dates and contract specifications
Every futures and options contract has a fixed expiry date. Keeping track of expiration cycles ensures better trade execution and risk management.
Strategies for futures and options trading
Hedging with futures
Futures contracts are widely used by institutional investors and businesses to hedge against market risks. For example, a farmer can lock in a price for crops using commodity futures, reducing uncertainty in income.
Covered call strategy in options
A trader holding a stock can sell a call option at a strike price higher than the current market price, earning a premium while retaining ownership of the stock.
Straddle and strangle strategies
These options strategies help traders profit from market volatility. A straddle involves buying both a call and put option at the same strike price, while a strangle involves selecting different strike prices.
Spread trading
Traders use spreads to limit risk while taking advantage of price movements. Common spreads include bull call spreads, bear put spreads, and butterfly spreads.
Risks involved in futures and options trading
While futures and options offer significant opportunities, they also come with risks.
- Leverage risk – Derivative trading allows traders to take larger positions with smaller capital, increasing the risk of losses.
- Time decay in options – As expiry nears, the value of an option declines, impacting profitability.
- Market volatility – Unpredictable price swings can lead to margin calls or unexpected losses.
- Liquidity risk – Certain contracts may have low liquidity, making it difficult to execute trades at desired prices.
Conclusion
Future and options trading provides investors with flexible opportunities to profit from market movements, hedge risks, and diversify portfolios. While futures contracts require a strong risk appetite and capital commitment, options offer flexibility with limited downside risk.
Choosing between futures and option trading depends on individual goals, trading experience, and financial capacity. By understanding how these derivatives work, using effective strategies, and managing risks efficiently, traders can make well-informed decisions in the stock market.
For those new to derivatives trading, starting with options may be a safer choice before moving on to futures. However, both instruments can be valuable tools when used strategically in a well-planned investment approach.
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