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In this article, we focus on trading options vs. futures for beginner traders. Futures and Options are stock derivative contracts between two parties that can be traded on stock exchanges. As these instruments derive their value from an underlying asset, they are called derivative instruments and the underlying assets can be equity, commodity, market indices, and so on. Future and Options contracts are required to be signed by both parties involved and are traded at a later date at the pre-determined price level.
Stock markets are prone to volatility and involve lots of uncertainties. As the direction of price movements cannot be predicted well in advance many times it leads to substantial losses. Futures and Options are usually used to hedge these market risks by locking off the price levels beforehand. This means these instruments basically help investors in reducing their investment-related future risks through a pre-determined price level.
The Top Advantages and Disadvantages of Trading Options vs. Futures for Beginners
Futures Contracts and Their Inherent Advantages and Disadvantages
A Futures contract is an agreement between two parties where one party commits to buying an underlying asset and another party agrees to sell that underlying asset at a specific price at a future date. The contract gets completed at an agreed date either by physical delivery, cash settlement, or offsets prior to the expiry date. However, in practice, these are closed out by paying the price differences and actual delivery rarely takes place. Also, Future contracts are standardized in terms of quantity or amount, and the margin levels on these contracts are usually determined by the regulators, commodity exchanges, or the brokers doing such business.
Advantages of Futures Contracts:
Futures have a lot of advantages that make them appealing to a lot of investors whether speculative or not. Some of these advantages are:
Stable Margin Requirements
As the margin requirements for most of the commodities and currencies are well-established in the futures market, there is little to no confusion on part of the trader regarding the margin requirements. Moreover, due to this one can sell contracts as readily as one buys them as the amount of margin required is always the same.
Futures can bring added flexibility to one’s portfolio as Future markets are usually highly liquid especially in cases of currencies, indexes, and commonly traded commodities. This allows traders to enter and exit the market at any time as per their own desire.
Lower Associated Costs
Commission charges on future trades are usually much lower like 0.5% of the contract value and are charged during the closing of the position. However, such charges depend on the level of service.
Futures are an excellent cost-efficient hedging device. Many times, companies having foreign trade exposure use future contracts to mitigate foreign exchange risk, or the commodity producers like farmers use it to manage the price risks associated with their underlying business or produce.
Disadvantages of Futures Contracts:
Futures also have certain disadvantages such as:
Following a Set of Standards
Future contracts work by following a set of standards. So, in case of events over which one does not have any control such as natural disasters, unexpected weather conditions, or political issues, the estimated demand-supply equilibrium gets disrupted.
Fixed Expiry Dates
Future contracts have a certain fixed maturity date. The price of the underlying asset sometimes can become less attractive during that maturity period, therefore, turning the entire contract worthless.
Option Contracts and Their Inherent Advantages and Disadvantages
An options contract is also an agreement between two parties that gives the buyer a right but not an obligation to buy or sell a stock, foreign exchange, commodity, index, etc. at an agreed price called the strike price on or before a specific date regardless of changes in the underlying assets market price during that period. Unlike Futures, the holder here is not required to buy or sell the asset if he does not intend to.
Options contracts can be of two types: Call and Put. A Call Option Contract provides an Option Buyer with a right but not an obligation to buy the underlying asset at the strike price in the future while a Put Option Contract gives the Option Buyer the right but not the obligation to sell the underlying asset at the strike price in the future. The Options Seller though is obligated to the decisions of the Option Buyer and charges a fixed premium from the buyer for bearing all the risk.
Advantages of Option Contracts:
Like Futures, the Option contracts too, come with a lot of advantages such as:
Options are highly cost-efficient and allow one to take positions with a very low capital base. An investor can obtain an option position similar to a stock position while saving a huge sum in the process. However, they need to judiciously pick the right option in order to mimic a similar stock position.
Lower Risk Exposure
Though many situations can arise where buying options are riskier than owning stocks, in most cases Options can be actually used to reduce the risk exposure. The amount of risk in options is predefined usually i.e., the maximum amount of loss a buyer can undergo is the amount of premium paid.
Usually, the returns on buying options are much higher than on stocks. This is because one can get options by paying a lower margin and can get the same profitability as he would have received in the case of stocks, thereby earning a higher percentage return overall.
Options allow the creation of unique combinations of strategies to take advantage of different market conditions like volatility and time decay.
Disadvantages of Option Contracts:
Higher Spreads and Commissions
Options usually have higher spreads as they lack liquidity thereby making the trader pay higher indirect costs. Besides, they also cost more in terms of commission per dollar invested.
Sellers Exposed to High Risks
Options sellers are exposed to unlimited losses and can sometimes incur losses much greater than the price of the contract.
Options are short-term-oriented investments capitalizing on near-term price movements and therefore not suitable for long-term investors.
Options are complicated for beginners. At times even some advanced investors find them difficult to comprehend.