The derivatives market is perhaps the most exciting and, at the same time, the most complicated. Futures and options are among the most widely used derivative instruments for hedging risk and speculating on price direction.
However, it is a sad fact that one can incur huge losses simply by misunderstanding these instruments. This article highlights the difference between futures and options, delineates call and put options, and lists 9 common pitfalls that traders should avoid while trading the futures and options segment.
Understanding Futures and Options
Futures and options are derivative contracts that derive their value from an underlying asset, whether stock, commodity, or index. Although these two instruments are derivatives, they work fundamentally differently.
1. Futures Contract
A futures contract is a contract in which two parties commit to exchange an asset for an agreed price during a specified future date. These are standardized contracts whose trading occurs on an exchange.
In the case of futures, the contract exists in such a way that no matter what happens in the market, both the buyer and the seller must honor the contract and perform the corresponding action of buying or selling the asset upon the expiration of the contract.
Key Characteristics of Futures Contracts:
– Mandatory execution once the contract reaches expiration.
– No premium is required to be paid upfront.
– Higher risk because of leverage and obligatory execution.
– Respondents are mainly used for speculation and hedging.
2. Options Contracts
In an options contract, the trader obtains the right but not the obligation to buy (call option) or sell (put option) the underlying asset at a predetermined price on or before a specified expiration date. Unlike futures, options contracts give the trader the priceless ability to execute the contract or not.
Types of Options:
A call gives the right to buy an asset at a designated price.
A put gives the right to sell an asset at a designated price.
Key Characteristics of Options Contracts:
- No obligation to execute the contract.
- Does require premium payment.
- Offers the ability to hedge in a lower-risk way than futures contracts.
- Can be used for further speculation and to generate independent income.
How To Avoid These 9 Trading Mistakes In Futures And Options
While the profit potential is high in these markets, traders tend to indulge in avoidable mistakes in the futures-and-options segment. The key nine mistakes, alongside some suggestions to avoid making them, are noted below:
1. Ignorance
Many traders jump into trading without knowing the A-Z view of the difference between futures and options, which practically blocks any possibility of making money. One should know how these derivatives work, the risk factors involved, and the market influences before trading.
2. Ignoring the Difference Between Futures and Options
One of the traders’ greatest disasters occurs when they treat the futures and options alike. With futures, there’s a binding commitment, whereas options are very flexible. Not recognizing these differences can lead to unintended financial loss.
3. Misjudging Calls and Put Options
Often, the traders misjudge how both call and put options work. Call options gain when markets are strong, while put options gain value as markets fall. Buying calls in a bearish market or puts in a bullish market will incur losses.
4. Over-Leveraging Positions
Leverage amplifies profits and losses alike. Futures contracts are particularly leveraged; even a slight movement can wipe a trader out. Leverage should be used with utmost care, and stop losses should always be taken into consideration.
5. Overlooking Time Decay
Options decay in value over time (theta). Many traders tend to hold their options contracts for too long, hoping for the next move to go favorable. In most cases, the premium decays considerably during such a hold. Always consider time decay in options.
6. Missing Stop-loss Orders
Stop-loss orders prevent losses by automatically triggering the closing of a trade through preset levels. Many traders would avoid employing stop-loss orders, leading to their breakdowns. Always determine a stop-loss level based on your risk profile.
7. Ignoring Market Trends and Volatility
Although there is high volatility in futures-and-options markets, traders who ignore trends, market news, and volatility and take a position without analyzing the price trends usually end up taking losses. Do a thorough analysis before going for a trade.
8. Too Long on Losing Positions
Some traders hang into a losing position, hoping for a break in their direction. In the futures market, this usually ends in a margin call, while in options, it spells out bad news when premiums expire worthless. It is essential to know when to cut your losses and run.
9. No Strategy in Place
Trading without a clear strategy is a setup for disaster. Successful traders work with specific structures, such as straddles, strangles, spreads, and risk-reward ratios, to maximize profits and minimize losses.
Conclusion
For traders to get ahead in the derivatives markets, a sound knowledge of the difference between the futures and the options, as well as the workings of call options and put options, becomes quite critical.
By avoiding these nine common trading blunders, you stand a chance of building discipline in the game, which ultimately goes a long way toward reducing your risk and maximizing your profits.
Above all, education, risk management, money management, and a good trading plan should constantly be at the top of your considerations, regardless of whether you are a novice or professional trader.
