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I’d venture to say that anyone who has invested in the stock market is familiar with buying, holding, and selling stocks. In fact, that’s the strategy I use for the majority of my investments: long-term buy and hold.
I buy stocks, whether individual companies, ETFs, mutual funds, etc., they go into an investment account, and more often than not, they sit.
The purchases happily reside in those accounts for years, which will turn into decades, until one day far in the future, I’ll decide it’s time to cash out my profits and put them to use elsewhere.
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But this long-term strategy doesn’t appeal to everyone. There are investors out there who prefer to be more active in the day-to-day happenings of the market. And one of the ways investors do this type of frequent trading is through buying and selling what are known as futures contracts (futures) and futures options (options).
Futures and options are a more complex way to trade. And today, we’re going to give you the rundown of:
- Key concepts to understand
- What futures and options are
- Key differences between futures and options and when to use them
Before we dive into exploring futures and options, there are two key ideas that are important to understand.
- Derivatives: A derivative is a contract that’s based on underlying financial assets, which might be commodities, indexes, currencies, stocks, bonds, or interest rates. Both futures and options contracts are derivatives, and they’re often used for speculation, risk management, and leveraging a position.
- Hedging: Many investors use futures and options to hedge transactions with the intention of reducing their risk of losing money while they execute on other trades and investments. You’ll find some investors using hedging as a form of insurance to keep their downsides shallow. And frequently, using derivatives contracts is the preferred way to hedge.
Now on with the show.
When I think about the future, it feels very uncertain. Maybe I’ll want to buy a house in 5 years, but who knows what home prices will be by then. I have no idea how much I’d even need to save to make a down payment. Wouldn’t it be great to be able to lock down the price of something in the future and know exactly what you’ll pay?
Futures contracts sort of make that a reality by allowing you to lock down the price of an asset or commodity for future purchase. In the contract, you’ll have a clearly defined price and expiration date. And you’ll pay a certain amount to make the contract happen, what’s referred to as the initial margin amount.
Futures are most frequently used as speculative trades. That means a trader will take an educated guess at the direction of a commodity’s price. Let’s look at an example using oil which is a popular trade in the commodity futures space.
Let’s say an investor speculates that the cost of oil will rise by the end of the year. In this case, the investor can purchase an oil futures contract that expires in December. If the futures contract is set at $60 and oil is traded in blocks of 1,000 barrels, the investor will purchase a position worth $60,000 (1,000 barrels x $60 per barrel).
But because of initial margins, the investor doesn’t need to put up $60,000 to purchase the contract, only a fraction of that which goes to the broker facilitating the trade. And while you’ll only need a small initial margin investment to start, you could potentially need to add money to your margin account to cover if the value of your speculative asset starts going in the opposite direction of your contract.
As the year goes on, the price of oil will go up and down as it does. Come December, if the oil price went up, say to $65 per barrel, the investor can sell the contract and exit their position. That means they’ll settle in cash and walk away with a profit of $5,000 ($65 – $60 = $5 x 1,000). Not too bad.
But if oil takes a massive dive and goes down to $40, the investor would be facing a loss of $20,000 ($40-$60 = -$20 x 1,000). Yikes.
The major benefits to futures contracts are:
- Companies can lock in prices ahead of time. Locking in a fixed price means a lower risk of being negatively impacted by a price change. For example, an energy company looking to reduce its risk might sell oil futures at a fixed price to ensure they make a certain amount of future profit. Then, if the price drops drastically, the seller will still get that agreed-upon price.
- You can use leverage to make a larger investment. Because futures contracts only require upfront payment of the initial margin, investors can get more exposure to potential gains for less money.
- Longer trading hours. Futures trade almost 24 hours a day, 6 days a week. No Saturday trades. (For comparison, options typically trade only between 9:30 and 4 pm ET.) This means futures traders benefit from being able to manage their positions more frequently.
But there are potential downsides to futures, notably:
- The future is unknown. Because nobody knows the direction any given commodity or asset will take, futures are bets. And that means you can win big or lose big, and unfortunately, you won’t know which until it happens. For example, if you choose to lock into a contract for a crop like wheat or corn, you’re at the mercy of mother nature to decide if that harvest will be great or go bust.
- More leverage also means greater potential losses. Traders risk losing out on their initial margin and then some if the asset price falls below the agreed-upon fixed price. As the expiration approaches and prices fluctuate, you may need to add more cash to your margin account to cover.
What are Options Contracts?
I’ve worked at several young software companies over the last decade. And as part of the benefits package, I was given stock options. Options are far more appealing to small employers than gifting actual shares of stock.
That’s because an option is, well, optional. You’re not required to buy options. But you have the choice to do so.
When I received my stock options, the employer gave me a set price, known as the strike price, and a set number of shares.
And all that meant was at some time in the future (before the contract’s expiration date), I had the option to purchase those shares at that set price, regardless of what the stock was actually worth by the time I got around to buying it.
While I had an options contract through an employer, you can also purchase options like you’d purchase shares of stock through a brokerage account. But you’ll need to pay a premium for the option to purchase the stock.
The premium is essentially a nonrefundable deposit you pay for the opportunity to buy the option. Options come in two flavors, calls and puts.
Calls vs. Puts
A call option is what I received at my jobs, the option to buy a set number of shares at a specific strike price by a certain date. But it really only makes sense financially to call options if the stock price goes higher than the strike price.
For example, let’s say you have an options contract for 10,000 shares with a strike price of $1. If the stock jumped to $5 before your contract expires, you’d probably want to exercise those options.
By turning around and selling those shares immediately, you could turn a quick $4 profit per share. And if you had access to 10,000 shares in options, that’s a quick $40,000.
But where a call option can bite you is if your strike price for the option is $1 and the stock dips below to only trade at $.75. In that case, the option holds no value. So you’d be wise to simply let the call option expire as worthless and take the loss on whatever premium you paid to buy it.
A put option is used by someone who already owns an asset and wants to have the option to sell a set number of shares by a future date at a specific price. Put options tend to be popular purchases when investors feel a certain security is poised to fall.
For example, let’s say you have 100 shares of stock in Company A, but you’re starting to feel like maybe it’s about to tank. Since each options contract is 100 shares, you’d sell one put option for Company A, let’s say at $20. That means you can sell those 100 shares at $20 each until the expiration date of the options contract.
But also consider that you need to pay a premium for that contract. Let’s say that was $1 per share. So you’ll “win” in this case if Company A’s stock falls below $19 (your put option minus the premium).
If the stock fell to $15 by the expiration date, you would profit $4 per share, or $400. That’s opposed to losing $500 if you were forced to sell those shares on the open market. That means you saved yourself $80 by buying the put option since you paid $20 toward the contract. Make sense?
There are many benefits to options, including:
- Flexibility in execution: You can exercise options at any point prior to the date at which the options expire. Or you can choose not to exercise them at all! That’s the beauty of buying options when compared to futures. You’re not required to do anything if you don’t want to; you’ll just lose out on your premium payment.
- Limited liability: With buying options, you’ll only ever need to pay the premium to cover the option. With futures, you put up the margin and could need to add more to cover a price decrease. That means options have much less liability than futures.
But as with futures, options also have some inherent downsides:
- Sellers have lots of risk: Your risk is more well-managed when you’re the buyer. You pay your premium upfront, and if you decide not to buy, you’re no worse for wear. But selling options puts you in a position of obligation. That means when you sell the option, you’re agreeing to sell it for that fixed price on that date. The buyer can choose to execute or not. But even if you suffer a significant loss (or perceived loss if a stock drastically increases or decreases), you’ll still need to sell.
While very similar, futures and options also have key differences that are important to note before you lock in a sale or purchase.
- Futures require that you make the purchase while options are optional. Not trying to beat a dead horse, but when you buy an option, it’s optional to execute on it, and you can let it expire as worthless. If you want out of a futures contract, the only way out is through.
- You can use leverage to buy futures but not options. This means the maximum loss you can sustain on buying an option is the premium. But the leverage used to buy futures means you could end up needing to add more to your margin account in time.
- Options help investors hedge against uncertainty, while futures are mainly used by businesses to lock in market prices. Buying and writing options can help you manage stock market risk, especially in a sudden downturn. But the primary purpose of futures is for businesses to make sure they’ll be profitable by locking in a future market price.
All investments are inherently volatile. And just like there’s no guarantee you’ll make money on futures and options contracts, there’s also no guarantee that you’ll make money on stocks and bonds either. That said, it makes sense to dabble in futures and options when you’ve done sufficient research.
If you, like me, are still new-ish to the stock market game and you’re more risk-averse, options and futures might be something to read up on, but not necessarily get into right now.
But if you have the time and energy to dive deep into options, futures, and the industry knowledge necessary to be successful trading them, by all means, they’re out there for the trading.
The Bottom Line
Trading futures and options, as with any stock market investment, is a risky endeavor. And that means you’ll need to do a ton of research and make sure you fully understand and are willing to deal with the risks before you put any money down. So as you think about using futures and options for investing, consider:
- Many traders view futures and options as “insurance” to hedge against the potential downsides of other investments.
- You need to understand the company, commodity, or asset class you plan to invest in through and through. That means you’ll need to know what economic conditions may affect the future of business and competition within the sector.
- You’ll need enough cash to cover potential losses. While you can limit your downside using futures and options, you’ll want to keep a couple thousand dollars extra in the till to cover potential losses.
This article barely scrapes the surface of futures and options, and trust me when I say my head has been spinning just thinking about them.
If you’re interested in trading futures and options, you’ll want to connect with a broker that can assess your financial situation and approve you for trading if eligible. As with any investments, only put in what you’re willing to lose and if you can’t take the heat, stay out of the stock market kitchen.