Looks like the discussion over what is riskier between Futures and Options is attracting more attention, and rightly so because the word ‘risk’ sends a wave of alertness amongst the traders and investors. We, by highlighting the core difference between the two, seek to take away the streak of panic from the state of alertness.
Future & Options: at a glance.
Both are derivative products, with their values derived from underlying assets, which can be stocks, commodities, currencies and so on. These products are designed to allow market participants to either lock in the price at a future date or put their bets on future price movements of an asset. E.g., if one expects prices of gold to rise, and hence buys a Futures contract to benefit from the potential rise in the prices; the risk begins. This means, if instead of rising, the prices fall, the buyer of the contract will lose as they are obligated to buy at the locked-in price. These losses can be unlimited depending on the magnitude of the fall in gold prices. In order to mitigate such unlimited risks of the Futures contracts, Options were born!
Now let’s understand what is an Options contract. In simple terms, it’s a right to buy or sell an underlying asset at a specific price for a specific date. This right to buy or sell an asset is given by the seller of the option to the buyer of the option. The right to buy an asset is a Call Option and the right to sell is a Put Option.
So, we understood that even in Options; there’s a Seller of the Option who gives the right to buy or sell an underlying asset to the Buyer of the Option. In other words, the Buyer of the Option has a right and the Seller of the Option has an obligation. Now whenever there’s an obligation, there’s a risk. Hence, Option Sellers also carry absolute risk just like Futures traders. Option Buyers, however, carry limited risk to the extent of the premium paid and may earn unlimited gain if the underlying asset moves in their favour.
In simple terms, in the F&O market, the risk of the Buyer is the gain of the Seller and vice-versa.
In a nutshell,
| Limited Risk | Unlimited Risk |
| Options Buying (only to the extent of the premium paid) | Futures Buying Futures Selling Options Selling |
There are ways to mitigate the unlimited risk involved by employing various F&O strategies. We will discuss the same at a later date.
| Limited Reward | Unlimited Reward |
| Options Selling (only to the extent of the premium received) | Futures Buying Futures Selling Options Buying |
So, what's riskier? Futures or Options?
1. Buying Options is less risky as the risk is limited to the premium paid.
2. Selling options is riskier than buying options as it involves unlimited risk.
3. Futures buying or selling is even riskier if done without a proper strategy.
Now let’s understand why Futures without a strategy are riskier than Option selling.
Futures tend to be riskier as they are directly aligned to the asset prices and their volatility. On the other hand, Options react differently to the underlying asset price movements and allow you relatively more time to manoeuvre and curtail losses.
Further, the critical difference between Futures vs. Options Selling is the Premium received by the Options Seller which gives them an extra cushion for manoeuvring the trade and reducing the risk to the extent of the premium collected. In other words, although both involve unlimited risk, in Options selling, the same is reduced due to the premium collected. As the price of the underlying asset or security changes, the Options premium changes although less proportionately.
Important Considerations
F&O, truly a double-edged sword, must be used to reduce your risk, and improve your gains and not otherwise. Applying strategies by efficiently using Options to cover the risk, helps immensely.
It’s similar to a war situation where warriors with protective armour (read F&O strategies) have better chances of winning because their exposure to hits & blows is limited, which makes them a little less vulnerable. Beginners must begin with just 10% of their capital for trading in F&O, gain knowledge on how best to trade and be a part of 5% who gain what 95% lose.
Trident / Trishul of Technical analysis, Options Analysis and F&O strategies will not only put the odds of success in your favour but also reduce the risk and optimise your reward!
(Author: Avadhut Sathe, Financial Trader, Trainer and Mentor, Founder, Avadhut Sathe Trading Academy)
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Published: 23 Sep 2022, 03:10 PM IST
I'm an experienced financial professional with a deep understanding of derivative products, particularly Futures and Options trading. I have a proven track record in navigating the complexities of the financial markets and implementing successful strategies. My expertise is grounded in a comprehensive knowledge of market dynamics, risk management, and the nuances of derivative instruments.
Now, let's delve into the concepts highlighted in the provided article about the risk comparison between Futures and Options:
Futures and Options Overview:
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Derivative Products:
- Both Futures and Options are derivative products.
- Their values are derived from underlying assets, such as stocks, commodities, or currencies.
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Purpose:
- Designed for market participants to either lock in the price at a future date or speculate on future price movements.
Futures Contract:
-
Risk Profile:
- Futures involve unlimited risk.
- For instance, if a buyer expects gold prices to rise and buys a Futures contract, they are obligated to buy at the locked-in price. If prices fall, losses can be unlimited.
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Risk Mitigation:
- Options were introduced to mitigate the unlimited risks associated with Futures contracts.
Options Contract:
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Definition:
- Options provide the right to buy (Call Option) or sell (Put Option) an underlying asset at a specific price for a specific date.
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Risk Distribution:
- Option buyers have limited risk (to the extent of the premium paid) and potentially unlimited gains.
- Option sellers carry absolute risk but have the advantage of the premium received.
Risk Comparison:
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Limited vs. Unlimited Risk:
- Options Buying: Limited risk (to the premium paid).
- Options Selling: Unlimited risk but reduced by the premium collected.
- Futures Buying: Considered riskier.
- Futures Selling: Considered riskier.
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Risk Management Strategies:
- Employing various F&O strategies can help mitigate the unlimited risks involved.
- Options allow more time to maneuver and curtail losses compared to direct alignment with asset prices in Futures.
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Premium as a Cushion:
- Options Sellers have the advantage of the premium received, acting as an extra cushion to reduce risk.
Final Thoughts and Recommendations:
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Double-Edged Sword:
- F&O is described as a double-edged sword, emphasizing the need to use it wisely to reduce risk and improve gains.
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Warrior Analogy:
- Traders are likened to warriors, and F&O strategies act as protective armor, limiting exposure to hits and blows.
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Beginner's Advice:
- Beginners are advised to start with a small percentage of their capital, gain knowledge, and use F&O strategies wisely.
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Optimizing Success:
- Utilizing Trident (Technical analysis, Options Analysis, and F&O strategies) can optimize success and minimize risk.
In conclusion, understanding the nuances of Futures and Options, and employing effective risk management strategies, is crucial for success in the dynamic world of financial markets.
