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Previously in this column, we discussed why liquidity is important for trading European options, especially for taking profits on long calls and long puts. This week, we discuss why liquidity is not an important factor for choosing futures contracts as it is for options.
Futures Vs Options
The following two arguments show why futures differ from options with respect to liquidity: One, all futures contracts have only three maturities — near-month, middle-month, and farther-month. If a given number of market participants intend to trade futures on an underlying, they must either go long or short on one of the three contracts. Now, for most part, volumes are concentrated on the near-month contract. Therefore, near-month contracts on all underlying assets have good liquidity. In contrast, options have multiple strikes for each expiration month. For instance, NSE offers 20 in-the-money (ITM) strikes, one at-the-money (ATM) strike and 20 out-of-the-money (OTM) strikes on Reliance Industries. With more choices, volumes are divided between these strikes. Therefore, selecting a strike based on liquidity becomes very important.
And two, a futures contract moves one-to-one with the underlying price. Therefore, traders have little reason to shift their existing futures position to another contract on the same underlying to align the position with their price target. In contrast, options have an upfront cost (premium) that decays with time. To reduce time decay, traders may take profits sooner than later. And to capture further upside price movements, traders continually shift their positions, sometimes to strikes with the same expiration date. That means volumes are closely tied to the moneyness of an option — whether an option is ATM or OTM.
It is true that near-month futures contracts on some underlying such as the Nifty Index and Reliance Industries are more liquid than others. While lower liquidity may not significantly affect the opportunity to take profits as is in the case of European options, it would have a bearing on the magnitude of profits; greater the liquidity, the lower the bid-ask spread. As futures price mirrors its underlying price, a lower bid-ask spread on futures price means you would be able to capture profits that are closer to the gains on an equivalent underlying position.
Optional reading
Liquidity in derivatives trading relates to two factors — delta and absolute price. The delta of a futures contract, which captures the change in the futures price with respect to a change in the underlying, is close to one. So, whether you buy the near-month, the middle-month or the farther-month futures contract, the futures price will not be far away from the underlying spot price. In contrast, depending on the strike, the delta of an option could be lower than 0.50, close to 0.50 or greater than 0.50. This means the absolute price of an option will differ significantly across the strikes on an underlying. Also, because options have time decay, traders do not want to pay a large premium to initiate a long position. Therefore, traders prefer ATM and OTM strikes, reducing liquidity for all other strikes at any point in time.
Note that the futures price carries an interest factor to account for the fact you pay only an initial margin and not the entire amount as in the case of spot market transactions. This interest factor is higher for middle-month and farther-month contracts compared to the near-month contracts. That explains why the futures price is typically greater, the longer the maturity. For instance, at the time of writing this article, the farther-month Nifty futures contract was trading 120 points more than the near-month contract, and 127 points more than the spot index value. Note that at expiry, futures price converges with the spot price. So, higher the amount you pay over the spot price to initiate your long position, lower the profits. Therefore, traders typically prefer near-month futures to farther-month contract.
(The author offers training programmes for individuals to manage their personal investments)
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