In this article, we will discuss
- Risks of Options Trading
- Risks of Futures Trading
- The Bottom Line: Which is Riskier Between Options Trading and Futures Trading?
Futures and options trading in India has been gaining momentum over the past few years. However, because of inadequate risk measures and a general lack of awareness, retail traders have been facing mounting losses. A report by the Securities and Exchange Board of India revealed that 90% of the retail trading population (or 9 out of 10 traders) lost money in F&O trading in FY22 alone. Using reliable platforms like the Samco trading app could make it easier for you to navigate these risks effectively. This app offers tools that allow you to understand the complexities of the market and manage risks in F&O trading more effectively.
To ensure that you reduce the chances of losses in F&O trading, you need to first understand the risks that futures and options each entail. Let us take a deep dive into these crucial aspects.
Risks of Options Trading
To figure out which is the riskier of the two between futures and options trading, let us take a closer look at the risks in the options market segment. The top downsides include:
Leverage and Potential for Total Loss
Options trading inherently involves leverage, which can magnify your gains and losses. When you buy options, your maximum loss is limited to the premium paid. However, depending on your position sizing, this premium can be a significant percentage of your investment budget. If the options expire worthless, you will incur a total loss. Also, depending on the options trading strategies you choose, the potential for losses may be increased multifold if the market does not move favourably.
Time Decay or Theta Risk
Options are considered wasting assets because they lose value as time passes. This phenomenon is known as time decay or theta. The risk is particularly high for out-of-the-money options and it only increases as the expiration date approaches. As an options buyer, time is working against you and you need the underlying asset’s price to quickly move in your favour — so it can offset the loss from the time decay. As an options seller, time decay may work in your favour. However, your maximum profit may be capped at the premium received but potential losses can be unlimited if the market moves unexpectedly.
Volatility Risk
Options prices are sensitive to changes in implied volatility, which is represented by the Greek letter Vega. A sudden decrease in implied volatility can pull options prices down even if the underlying asset’s price has not moved significantly. This risk can particularly impact options buyers in F&O trading because increased volatility typically leads to higher options prices. Conversely, options sellers benefit from decreasing volatility but face risks if the IV spikes unexpectedly. Given the nuances of volatility risks, it is crucial to understand and manage this downside smartly.
Limited Time to Make the Right Move
Unlike stocks, which can be held indefinitely, options have a fixed expiration date. This means you not only need to accurately assess the direction of price movement in the underlying asset — but also need to time the trade well. Even if your directional estimate ultimately proves to be correct, your option can expire worthless if the price move does not occur before the option’s expiry. This time constraint brings in an added layer of risk to options trading.
Complexity and Possible Misunderstanding
Options trading is also highly complex. It involves complex terminology and requires the use of multi-legged options trading strategies that can be challenging for beginners. Misunderstanding key concepts like strike prices, expiration dates and options Greeks can open up avenues for unintended and unexpected risks. For instance, if you misunderstand the concept of Greeks like delta or theta, it could leave you unprepared for changes in the option’s value as market conditions shift. The complexity further increases with multi-legged options trading strategies like spreads and straddles, where the presence of different options contracts in one trade can pose various types of risks that you may not be aware of.
Liquidity Risk
Like every other segment in the financial markets, options trading can also be prone to liquidity risks. Some options, particularly those that are far out-of-the-money (OTM) or have distant expiration dates, can be illiquid and difficult to trade. This lack of liquidity can lead to wider bid-ask spreads and make it challenging to enter new positions or exit existing trades at favourable price points. In extreme cases, you may even find it tough to close out a position at all, potentially leading to missed opportunities or increased losses. This risk is particularly prominent in
Risks of Futures Trading
Like options trading, buying and selling futures also comes with a unique set of challenges. Before you identify and implement the best futures trading strategies, you must familiarise yourself with the risks in this segment, which include the following:
Unrestricted Liability
Unlike options trading strategies, where the buyer’s losses are limited to the premiums paid, futures trading carries the risk of unrestricted liabilities. This means your potential losses are not capped and may exceed your initial investment — ultimately making you lose money in the market. For example, if you short a futures contract and the underlying asset’s price skyrockets, you will have to fulfil the contract at the agreed-upon price, potentially incurring significant losses. Unlike options, futures also do not offer the choice of letting the contract expire worthless. So, you are obligated to carry out your end of the trade.
High Leverage and Margin Calls
Futures trading also typically involves high leverage. This allows you to control a large contract value with a relatively small initial margin. On the upside, this can amplify your profits. However, on the flip side, your potential for losses is also exponentially increased. If the market moves against your position, you may have to deal with margin calls and deposit extra money to keep your position open. In case you fail to meet these calls, your position may be automatically
Market Volatility Leading to Price Fluctuations
The futures market can be highly volatile, with prices often experiencing rapid and significant fluctuations. This volatility may be due to reasons like economic data releases, geopolitical events, weather patterns (for agricultural commodities) or sudden changes in demand and supply. These price swings can quickly turn a profitable position into a losing trade. The quick turnaround cycles in many futures trades may also lead to significant price shifts overnight. This could potentially lead to gap-up or gap-down openings that may bypass stop-loss orders and lead to unexpectedly large losses.
Liquidity Risk
Some futures contracts may be highly liquid. However, the less popular or more specialised contracts may suffer from low liquidity. This can lead to wide bid-ask spreads and difficulty in entering or exiting positions at preferred prices. You may also find it tough to close positions on time, which could, in turn, lead to large and unexpected losses. Liquidity risk in futures trading strategies can be particularly problematic during periods of market stress or when trading in markets with limited participants. It's crucial to assess the liquidity of the specific futures contract you're trading and consider how this might impact your ability to manage your positions effectively.
Counterparty Risk
Although the market has measures in place to manage counterparty risks, it is never non-existent. This is the risk of the other party in the contract (or the clearing house) defaulting on their obligations. While this is quite rare, it is still a prevalent risk — especially in unregulated markets. This risk can amplify based on the position sizing chosen for a particular trade. So, it is vital to understand the financial stability of the exchanges and clearing houses in order to manage this risk in futures trading strategies.
Backwardation Risk
When trading futures, particularly for longer-term positions, you may face risks related to the futures curve structure. In contango markets, where future prices are higher than spot prices, rolling contracts forward can result in losses (negative roll yield). Conversely, in backwardation, rolling contracts can lead to profits. However, these curve structures can change and affect the profitability of the futures trading strategies that depend on them.
The Bottom Line: Which is Riskier Between Options Trading and Futures Trading?
Comparing the risks of futures and options is not straightforward. Both types of derivatives involve significant potential for losses. However, in general, futures trading is often considered riskier for the average retail trader.
This is because futures contracts typically involve higher leverage than options — meaning that a small investment can control a larger position. This exponentially increases the potential for both gains and losses — possibly leading to huge downsides if the market moves in an unfavourable direction.
Also, with futures, your losses can theoretically be unlimited as there is no cap on how far up the price can go. This is further compounded by the fact that you are obligated to fulfil your contract.
That said, options also have their own risks, as outlined above. Ultimately, the risk depends on how these instruments are used. Both can be extremely risky if not properly understood or managed. Proper education, risk management, and a clear understanding of your trading strategy are crucial regardless of whether you choose futures or options.
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