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Futures and Options
Futures and Options
Investing in futures and options
Futures
and options aren't for the faint of heart. These are sophisticated
investments that shouldn't be undertaken casually. Investors whose
experience is limited to less volatile, less leveraged and less risky
vehicles like stocks or bonds should be aware that options and futures
markets require a much stronger stomach for risk.
Even sophisticated individual investors should not approach them
without the counsel of qualified advisors, that is, fee-only financial
planners who don't earn commissions for the sale of these investments.
In addition, in order to understand the myriad factors affecting the
prices of options and futures, these investors should undertake their
own extensive study of these markets, and of the individual stocks or
commodities that they are thinking of trading.
If, after taking these steps, you decide that options and futures
aren't for you, you won't be in the minority. Yet, if you've got a
strong stomach for risk, options can provide a helpful hedge to protect
yourself from dips in stocks or indexes you already own, while futures,
in small amounts, can offer an alternative form of portfolio
diversification. In the sections that follow, we'll show you the best
ways to use them.
What You Need to Know
1.
Options and futures aren't for everyone! These are highly complex,
highly leveraged investments that require close watching and a high
tolerance for risk.
2. Nor are they for the lazy. Unlike stocks, which
can be purchased and held for years, options and futures are time-based
assets with deadlines for action.
3. Options require a basic knowledge of the stock
market. Beginners shouldn't get into options or futures without help
from a qualified advisor.
4. Futures are highly leveraged investment because
small amounts of money can control, and make you liable for large
amounts of a commodity.
5. Futures, if purchased in
relatively small amounts, can be helpful in providing portfolio
diversification. Also, practicing these investments on paper is a good
way to learn the mechanics, but doesn't simulate the emotions of
financial risk.
Time-Sensitive Investments
What
options are and how to get started investing in them
When
hearing the phrase "stock options," most people tend to think of
high-rolling executives who can now cash in on the incipient riches
that induced them to join their company several years ago.
But there is another kind of option that you can get in on, the
publicly traded kind. This type of option involves the investor's
belief about whether a given stock or index of stocks will rise or fall
in value within a set time period.
You can buy options to buy stocks (known as "calls") or options to sell
them ("puts"). A call is a contract to buy a set amount of stock at a
set price for a set time period, regardless of what the market does in
the interim. A put is a contract to sell a set amount of stock.
Accordingly, buyers of calls hope that the stock will increase
substantially before the option expires, so that they can then buy and
quickly resell the amount of stock specified in the contract, or merely
be paid the difference in the stock price when they exercise the
option.
Conversely, buyers of puts are betting that the price of the stock will
fall before the option expires, thus enabling them to sell it at a
price higher than its current market value and reap an instant profit.
All options are contracts for what is known as a "wasting asset", that
is, if the buyer of an option does nothing, the option to buy or sell
stock expires and the option becomes worthless. In an investment world
where many professionals subscribe to the buy-and-hold philosophy of
long-term investing, it is no wonder that these same professionals get
palpitations from the daily gyrations of the market. If they are
speculating in options, they can't be passive; the clock on options is
always ticking.
Within the time frame in the options contract (often a period of
several months), investors must evaluate the best time to exercise the
options or face losing the money they spent to buy them. In some
instances, the least costly alternative is to do nothing, as exercising
the option would cost more than letting it expire. Nevertheless,
holding options forces investors to keep a close eye on the market each
day, searching for the best opportunity to buy or sell.
What about those of us who aren't professional investors? What are some
approaches to options that are appropriate for you as an individual
investor who has other things to do besides obsess over the market?
Here are a couple:
-
Get your feet wet by buying
options, and avoid selling them. The most you'll lose by buying options
will be the price of the options contract itself, which is known as the
premium. If you think prices will increase, buy calls. If you believe
they'll nosedive, buy puts. Until you're seasoned, and this seasoning
can include some bitter tastes of the market, avoid selling options.
When you sell the stock, you could actually be expected to deliver,
possibly at a price far below what you can buy it for according to your
contract. Or you could be expected to buy it at prices far higher than
its current market value. Either way, these investments known as
uncovered options, because they are not backed by underlying shares.
Which can be highly leveraged and thus you can lose you your shirt.
-
Use puts as portfolio insurance.
Buying puts can protect your portfolio against market drops. For
example, if you own a substantial amount of a given stock, puts can
reserve the right to sell this stock at a given price as a means of
recouping some of your share-value losses. Of course, it's sometimes
more advantageous to simply liquidate some of the stock. However, if
you do this and the stock subsequently skyrockets, then you'll have
missed out on those gains. Thus, puts are a way to hedge against
share-price drops without divesting. The trick is to buy the right
ratio of puts to actual shares, based on your assessment of the stock's
downside and the cost of the puts.
-
Use puts as a hedge against
indexes you own. Puts can be used in the same basic way to protect, or
maintain a hedge, against losses in a given index of stocks. However,
it is paramount that these puts closely match the indexes that they're
purchased to protect. And, as an individual investor, it's best to
stick with puts on indexes that you already own, in the right
proportion to the amount of the index you own.
The Skinny on Futures
Why you might want to invest
in them
Futures:
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Futures come in many varieties.
Some examples are contracts hinged to the future performance of
currencies, stocks, bonds or other assets. Insofar as a futures
contract's value is contingent on the performance of another asset,
these types of futures technically are a form of derivative. These can
get extremely complicated. For example, some futures are contingent on
the S&P 500-stock index's performance. |
Others
are tied to foreign currencies, interest rates and precious metals.
The most traditional variety of futures is tied to commodities. These
futures are contracts that commit the investor to deliver or receive a
quantity of specific goods. Anything from pork bellies to live cattle
to apples, at a price determined by auctions held at a futures
exchange.
As with options, time is of the essence. Futures holders have a set
amount of time to decide what they're going to do. Unlike stocks,
futures can't be bought and left unattended for years. In this sense,
they can be a nerve-wracking asset to own.
The
amount invested in the
futures contract is called the margin. The price of the commodity
itself is due when the contract expires. At this point, investors
theoretically would take or make delivery of the commodity concerned.
Does this mean that if you invest
in futures, you'll someday find a
huge pile of pork bellies on your lawn with an astronomical invoice
attached? Hardly.
Almost no one actually takes or makes delivery (and those who do use
warehouses). Before the contract expires, you can do what's known as
"squaring your position" by paying or receiving the difference in the
current market price of the commodity versus the price stipulated in
your contract.
So, if few people are actually taking or making delivery of
commodities, you might ask why this market exists in the first place.
The answer is to spread risk. For example, pork producers have a pretty
precise idea of what it will cost them to raise today's piglets into
tomorrow's pork chops. What they don't know is how much these chops are
going to be selling for when the grown pigs are slaughtered, in part
because they don't know what the supply will be. That's where investors
come in. In buying pork futures, they buy a piece of the risk that
those in the industry face when they make long-term investments in
their livestock.
Despite the important economic
role of futures, this investment is
approached by many as though it were radioactive. Indeed, futures can
be risky, chiefly because they are highly leveraged investments,
meaning that large amounts of a given commodity can be controlled with
a small margin investment. Margin, after all, is essentially a
performance bond stating that you assume the financial risk of the
commodity's volatile price. So you can be on the hook for amounts far
greater than you've invested.
Of course, this leverage works both ways: By investing small amounts,
you can reap huge profits quickly. Or you can lose your shirt just as
fast. Indeed, your chances of coming out ahead aren't statistically
good. Some studies have shown that twice as many people lose money in
individual futures as make money. Such findings have prompted experts
to advise investors to stay away from futures unless they have some
money to burn, as they would for a trip to Las Vegas or Atlantic City.
Yet there are some aspects of futures that are not as austere. Futures
funds, if well managed, are less risky than picking individual futures.
Allocating a small percentage of your assets to a respectable futures
fund may serve as a helpful form of diversification for your portfolio,
even if the returns are low. A warning, get a qualified adviser to help
you evaluate funds.
Also, keep in mind that not all
futures investing is speculation. There
are two forms of futures investors, speculators and hedgers.
Speculators use the leverage of futures to try to score large profits,
while hedgers use the market to offset, or hedge, risks to other types
of investments in their portfolios. Using judicious futures investments
as a hedge over the long haul can provide portfolio protection with
returns that are lower but much more predictable than a speculator's.
After you gain enough experience to choose individual commodities,
choose prudently, and don't get sucked in by low prices. Too many
investors spread their futures money over too many commodities, more
than they could possibly research or understand. Commodities with
higher margins may cost more to get into, but that's because their
value is less volatile. As with bonds, lower prices mean higher risk.
Above all, keep in mind that to win the game, you need the right
marbles. The main reasons that individual investors lose money on
futures are that they are under-informed, under-capitalized, and
undisciplined (and so let their egos rather than their original plans
control their trading). Experience also counts for a lot. The best way
to get experience is to practice futures trading on paper, hardly a
test of your emotional mettle in situations where real money is
concerned, but helpful for getting a handle on the mechanics of
investing in futures.
Futures and Options
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