The derivatives market started in India quite late. It was only when the erstwhile Badla and the ALBM were banned in India that online trading in derivatives were introduced in India in 2001. While the early years were quite insipid, the momentum really picked up post 2004. Currently, if you look at the daily turnover, the future and options trades account for over 95% of daily turnover with cash equity accounting for less than 5%.
Futures versus options
Futures are a lot more straightforward. You try to leverage positions with a small margin and either buy or sell futures depending on your view in the market. Profits and losses can be unlimited irrespective of whether you are trading on the long side or on the short side. That meant that futures were still risky. That is where options became so popular in India. Options are a right without an obligation. A right to buy without an obligation is a call option whereas a right to sell without an obligation is a put option. Also there are options on the indices like the Nifty and the Bank Nifty as well as on individual stocks on which F&O is permitted. Let us now look at the pros and cons of index and stocks options.
Positives of stock options and index options
You are not restricted only to stocks but you can also play on sectoral indices like Bank Nifty and general indices like the Nifty. If you want to bet against a stock, buying put options limits your potential losses to the amount of premium paid on the option. On the other hand, if you short sell in cash or sell in futures, your risk is unlimited if the stock price movement goes against you.
If you want to borrow and invest, don’t go to a lender. Just go to the options market and buy options. It is like leverage. By buying options instead of the underlying stock, the trader can theoretically generate the same amount of profit over time with a much smaller up-front investment. And your maximum risk is also limited.
How do you play increase or decrease in volatility if you are not sure of the direction? Options can help. Both calls and puts gain value if volatility is increasing and lose value when the volatility is falling. Options can also be used to set up complex volatility- and time-sensitive trades. Stocks are discrete in nature as are futures. They essentially give the trader only two choices: buy or sell. By buying and selling a combination of different puts and calls at different strike prices and expiration dates, an options trader create very sophisticated strategies like straddles and strangles to play on volatility without trying to predict the market direction.
One of the most important roles that options play is to help you to hedge your risk. If you are long on SBI and are worried that SBI could move down sharply before bouncing back; what can you do? Just attach a put option to the stock and leave it. What you lose on the stock will be compensated by the put. On the upside your profits are unlimited once the option cost is covered.
Downside risks of options trading
The single biggest risk to options trading is time. This is more so when you are the buyer of the option. The seller of the option actually benefits from time compression. Stock options contain time value that is constantly decaying. A stock buyer has an indefinite amount of time to be right on his or her thesis. An options trader, in contrast, has normally only one month and in a best case scenario can have two months if you factor in the liquidity aspect.
Globally, nearly 70% of the options expire worthless. That means; more often the sellers of the options make money while the buyers of the option just tend to lose their premium and take that loss.
Taxation is a major challenge in case of options trading. Normally, options profits are shown as business income. In case it is shown as capital gains, it is treated as short term capital gains and taxed at the peak rate applicable. That reduces the post tax returns on options.
Leverage swings both ways. While it serves as an advantage when investors are correct, option traders can really take a big hit when wrong. Also it is a myth that you only lose the premium. When you lose the premium 3-4 times in succession, it is really hard to get the conviction to take additional options positions. That is the practical problem.
There’s no simple answer to the question of whether option trading is better or worse than stock trading. The most important part of the equation is that traders must be properly educated about the pros and cons and understand what they are getting into.