What to trade - Futures or Options in currencies?
I frequently come across people from the Trading field who are biased towards trading Futures as compared to Options. Nearly 70% of the people whom I have communicated or talked favour Futures trading. Now Futures contract at present is available for Indices, Currencies, Stocks and Interest Rates. It is also noteworthy that Options are also available for trading in Indices, Stocks, Currencies and Interest rates. Let’s take a deeper dive into these two derivative products and several pros and cons of trading in Futures and Options. It is to be noted that since this publication focusses on currency derivatives hence scope of discussion is limited to Currency Derivative Segment only.
There is a famous statement when it comes to trading and I think everyone should know about it — “If you trade with Futures there is no future, and if you trade with options you will have a lot of options.”
For those who do not know what is a Future contract, check out the following definition:-
According to Investopedia
“A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.”
Now, as per my understanding Futures are derived products whereas options are insurance against the potential risk of value degradation of a particular asset.
According to Investopedia Options definition:
“An options contract is an agreement between two parties to facilitate a potential transaction on the underlying security at a preset price, referred to as the strike price, before the expiration date.
The two types of contracts are put and call options, both of which can be purchased to speculate on the direction of stocks or stock indices, or sold to generate income. For stock options, a single contract covers 100 shares of the underlying stock.”
But for beginners, it can be tricky to choose the right product for trading. This statement is true even for traders with some experience. Usually, options are complex products which beginners and other traders find it difficult to understand and use. Naturally, the bias turns towards the Futures, and the traders continue to trade in Futures. In my opinion, Options are pretty cool products to trade. But I would not blame people for not picking up Options for trading. Media has played a pivotal role in reshaping the thought process of the traders. The very first statement traders will hear or read is “The Options are risky products”. Another common statement you will listen to or read is “The Option buying is less risky compared to option selling.” But in reality, big institutions earn heavily by selling Options as compared to Future traders or option buyers. Ask yourself “which financial product is not risky?”.
To add to the misery of the people, our Media and other biggies are not much interested in sharing their actual strategy of option selling. CDS is the most ignored segment in the trading arena. There is a noise in the market, and that noise consists only of Stocks future, Nifty Future, BankNifty, and commodities. Only Nifty, Bank Nifty options are promoted by almost 95% of the brokerage houses in the country.
Now if you trade only in Futures, you can speculate only in one direction i.e., it either has to go up, or it has to go down. Of course, StopLoss is an integral part of the play. There is no sense to take a trade-in Future contract if the markets are stagnant or indecisive. Indecisiveness can whipsaw portfolios hence it is not advisable to trade in Futures during that particular period. If there is a strong trend, then a single lot of Currency Future can give you whopping returns of Rs 1 in a single day.
At the moment there is no weekly Future contract available in CDS (Currency Derivative Segment), you can only trade in monthly Future Contract. Whereas you have the option to trade in monthly as well as weekly options contracts.
With options, there are so many strategies which can be deployed, and it becomes overwhelming for the amateurs and even experienced traders to learn and implement these strategies.
If the market is stagnant or indecisive for a long time, then you cannot trade in the Futures contract. The result would be damaging your portfolio. However, the stagnant or indecisive market is the best opportunity for option sellers, and they can earn by deploying non-directional strategies. Time is their friend. With time options’ premium decays and thus the option sellers retain maximum premiums.
Options trading strategies can be deployed for any market that is the beauty of the options trading, whereas you can deploy Future trading strategies only for the trending market. Best months to earn in Currency Options is the month of Dec where currency markets are almost stagnant, and you get the movement of 5–20 paise up or down. This presents the best moment to deploy non-directional option selling strategies. In this situation, you cannot do Future trading in the long term. You might be successful on a particular day by trading Future where movement might be of only 20 paise, but the earnings will not justify the effort involved in deciding to take a Future trade.
If markets are trending then generally three types of trading strategies can be deployed in Options trading (though there are several strategies in this article I am trying to simplify things by showcasing the most common and generally used strategies). In contrast, only one trading strategy can be deployed using Future trading. If markets are trending upwards, you would go long in the Future contract and vice-versa.
Trending Market trading strategies
Future and Options trading strategies
Future Trading strategy in trending markets
On 6 Nov 2020 USDINR spot was trading at 74.2677 and the Dec Future was trading at 74.5025. Let us assume that you have formed an opinion that USDINR pair is going to trend in an upward direction (USD appreciates, INR depreciates) based on technical and news events you will go long on Dec Future contract. In the case of the downtrend (USD depreciates and INR appreciates), you will go short on Future contract. This is a simple Future trading strategy that can be deployed in the trending markets. Though some people use Future trading to hedge their positions, let’s keep that out of the discussion as we are targeting simple trading strategies and not the hedging strategies.
Options Trading Strategies in trending markets
Let us discuss the three simple strategies that can be deployed in trending markets.
- Buy Calls in an uptrend and buy Puts in a downtrend. Well, you can buy ITM or ATM Calls and Puts as per the trend and sit on your profits. For example, USDINR pair is trading at 74.5025 then the traders would buy 74.25 or 74.5 Call for an uptrend. Incase of downtrend the traders would buy 74.5 or 74.75 Puts. Of course, the conviction to take the trade and risk the capital has to come after taking the view of the market. In this case, Option buying will provide profits after paying a small premium.
- Sell Calls in a downtrend and sell Puts in an uptrend. This is the most simple strategy where you can sell OTM options as per the trend and collect premiums. If the USDINR pair is trading at 74.5025, then the traders would sell 74 and below Puts to collect the premium in case of an uptrend. In the case of a downtrend, the traders would sell 75 and above Calls. The more stronger is the trend, the faster decay of the premiums would happen, and you would be able to retain the maximum premium amount.
- Buy OTM Calls and Puts. This is a strategy deployed much in advance after you anticipate the market moves that would happen in the coming days. OTM calls and puts can be bought at a cheaper rate and then wait for the markets to move as per your desire. For example, based on USDINR quote of 74.5025 you can buy 74.75 or 75 CE in an uptrend. Both 74.75 and 75 Strike prices are OTM and would cost low premiums to fund the trade. In case of a downtrend, you can buy 74.25 PE or 74.0 PE, which are again OTM Puts. This strategy is a bit risky and tricky. The options will decay if the price doesn’t reach the desired level. This step is taken only when traders are confident of the strong move that would start soon.
Indecisive Market Trading strategies
There is no strategy for Future trading, and it is advisable not trade in Futures when markets are in consolidation or are stagnant. Only Options have an edge in this case, and certain non-directional trading strategies can be deployed for such scenarios.
Options Trading strategies for Indecisive Market
- Sell Put and Call or deploy strangle. This is a very simple options trading strategy where you sell OTM Puts and Calls with the view that markets would be trading in a fixed range. If a trader thinks that USDINR pair would be range-bound in December and the range is 74.5–75.5, in this case, the trader would be selling OTM Puts, i.e., all the puts below 74.5. He will also sell OTM Calls, i.e., all the calls above 75.5 to form a strangle.
- Deploy Iron-Condor. This is nothing but secured strangle where you would also buy OTM calls and puts to safeguard your strangle positions against any surprise movement. For example, as per strangle, we would be selling 74.0 PE and 76.0 CE, but we will also buy 73.5 PE and 76.5 CE in the same quantity and for the same expiry to insure our strangle positions.
So far, we tried to understand the difference between Future and options based on certain market moves and strategies. Let us try to understand the difference between these two on the basis of the cost of funding, taxation and other technical factors.
Cost Analysis
Funding Cost — You will require around Rs 2000 to 2500 as a margin to trade in USDINR Future contract. This margin figure can vary from broker to broker. Now for Option selling the calculation of margin is bit tricky and generally, the majority of the brokers would show the Future contract margin only. But in reality, the margin requirement reduces as the premiums start to decay. In case of option buying the funding, the cost is the same as the premium for that particular strike option. For example, if 74.0 USDINR PE costs around 0.2200, then one lot of PE option would cost you Rs 220 (0.22X1000). So the cost of funding in option buying is cheaper while the cost of funding future contract is higher.
Taxes — The taxes are high in future trading while it is less for options trading.
From the above figure where the trade was squared at the same price at which it was bought, you can deduce the taxes after ignoring the brokerage. This price calculation has been for one lot of Future Contract. The taxes come around Rs 1.48. I have not taken GST into count because it is calculated on the basis of the brokerage charged by the broker.
Now from the above figure, you can deduce the taxes on a lot of options contract which comes around 0.04, which is drastically less than the taxes on Future contract. Obviously, we have to ignore the brokerage and the GST to calculate actual taxes.
Why am I not considering GST and brokerage for calculation of taxes? The answer is simple different brokers have different brokerage plans, and these figures would change. Finvasia does not charge anything on trade; hence for them, the Brokerage and GST on brokerage would be nil.
Technical aspect
Future trading follows the technical patterns which underlying assets follow. So it is a kind of trade where you take trade only when you are confident that markets are going to trade. Volatility factor no doubt plays an important role but let us assume it is the same for both Future and ATM option. In options trading, different options have different volatility which many traders also refer to IV or implied volatility.
Here is an analysis for intraday trade for ATM option trade vs Future trade.
What if instead of taking Future trade (1 lot) buy ATM options? Will the ten paise move in Future contract would yield the same result for ITM option price? Think again about it? Something called options Greeks comes into the picture. Delta of ATM and ITM options (the change of options premium) changes slowly as compared to Future price. Since you know now that Delta is a bit lower, you can easily exploit this theory to your own benefit by increasing the lot size. In short in Future trade, where Risk to reward ratio is 1:1, you will get 1:2 risk to reward ratio for ATM options trade when the position size is doubled as compared to a future contract. Now the funding cost to buy two lots of ATM or ITM options would be less as compared to fund a single lot of Future contract.
It also means that if the market is trending against your desired move, you will lose less money in options trade as compared to Futures trade because of the delta or the change in premiums. In another article, I will explain in detail how this theory works.
Conclusion
Based on the above discussion, we find that options trading is much more convenient and beneficial whether you are an intraday trader or a long term trader. Future trading has more funding cost as compared to options trading, and taxes are higher for Future trading as compared to options trading. On Technical perspective, it is more convenient to trade in ATM and ITM options as compared to Future trade. Incase markets are non-directional then Future trading is a failure, whereas options trading is useful and effective in such type of scenarios. Now, due to the media hype, traders try to stay away from options and prefer Futures trading. Definitely, it is high time that we should prefer options trading as compared to future trading.
