Derivatives

Why futures are preferable over options for momentum trades

Venkatesh Bangaruswamy | Updated on November 06, 2021

Futures moves almost one-to-one with the underlying

Traders typically buy momentum stocks. This strategy refers to buying stocks on decisive price breakouts from a major resistance level. But what if you want to trade derivatives for price breakouts? In this article, we discuss why futures are preferable over options for such trades.

Capturing gains

The objective of a momentum trade is to capture the swift price movement in the underlying. You can capture these gains by going long on the underlying. But if you prefer derivatives, you should consider futures. Why?

Futures moves almost one-to-one with the underlying. So, if the underlying moves up 50 points during the life of the futures contract, the futures price is likely to move by 50 points. Note that there would be a sizeable difference between the underlying and its futures price when the company has announced a corporate action such as cash dividends or bonus shares. You should be mindful for this factor when you are trading breakouts that are caused by surprise corporate actions.

Note also that futures price converges with the spot price at expiry. Suppose the futures price is greater than the spot price by two points when you initiate a long position on a price breakout. You will lose these two points if you hold the futures position till expiry. But any time before expiry, futures is likely to move in lockstep with the underlying. It is, therefore, better to take profits on a futures position before expiry.

In contrast, options do not move one-to-one with the underlying. An option price comprises of intrinsic value and time value. The time value of the option, in turn, comprises of time to maturity and implied volatility. The intrinsic value of the option moves one-to-one with the underlying. But the time value of the option declines every day and becomes zero at option expiry. This has a significant bearing on your trading strategy.

Suppose you buy an at-the-money (ATM) call option on an underlying that has just broken out of a major resistance level. Further suppose you paid 30 points (represents time value) to buy the option and the underlying moves up by 50 points a week later. The intrinsic value of the call option will move up by 50 points, but the time value could decline to 12 points (from 30 points). Therefore, the option cannot capture the entire gains from the underlying price movement.

Note that if the underlying continues its upward movement swiftly after the breakout, the option may not lose significant time value. But you cannot easily fix a time frame as to when your price target will be achieved using technical analysis. And the issue is that betting on options for breakout trades could result in lower profits if the stock moves up slowly after the breakout or pauses for a while after the breakout before continuing its uptrend.

Optional reading

Yet, if you want to trade options for price breakouts, then consider setting up a bull call spread. You can go long on an ATM call or an immediate out-of-the-money (OTM) call if it shows greater change in open interest. You should simultaneously short an OTM call that is one strike above the resistance level for the underlying. A call spread will reduce the loss due to time decay on the long call because you will gain from time decay on the short call. The maximum profit at option expiry will be the difference between the strikes less net debit to setup the spread. You can also combine long futures position with an OTM call.

One final note: Your entry price, price target, and stop loss should be based on technical analysis of the futures price when you are trading single-stock futures, index futures and index options. You should base your trading action on the underlying’s price charts for equity options.

The author offers training programme for individuals to manage their personal investments

Published on November 06, 2021

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