Futures and Options: What are They, and How to Trade Them

Introduction

Futures and Options: What are They, and How to Trade Them Learn about how to get started with futures and options, and what you should think about when including them as part of a responsible portfolio allocation.

If you're not already familiar, futures and options are two of the most common types of financial contracts. Essentially, they allow investors to speculate on the future price of assets or protect themselves from potential losses. They are often considered to be at the risky end of the investing spectrum, not least because they can have leverage associated with them. In this blog post, we will discuss what futures and options are, and how to trade them. Of course, the primary thing to consider here is risk management - these are non-standard financial assets, and need to be treated as such.

It is important to note before going further that speculative financial instruments are not for everyone. In fact, for the vast majority of public investors these should be nothing more than an esoteric interest or passing fancy - you are not going to get rich trading options. Let's say that again: you are not going to get rich trading options. Please be careful with your money. They can make up some of either the "fun" or "alternative" parts of your portfolio, but should stay at that. At the end of the day, enjoyable habits are habits that you stick to, and so why shouldn't investing be fun? Allocating a small portion of your assets towards risky bets is a way of keeping the "gambler" in you at bay, and introducing some fun into your investing journey. Read more about portfolio construction here. That being said, trading options is a great way of engaging in a more problem solving style of business, which can be fun for many an investor.

What are futures and options contracts and how do they work?

Ok, onto the good stuff. Firstly, what on earth are these things? Well, a futures contract is an agreement to buy or sell an asset at a predetermined price at some point in the future. This asset is often an equity. For example, you might agree to purchase a futures contract for one hundred stocks of Strabo Financial Ltd at $60 per share. If the price of the share rises to $70, then you would make a return of $10*100 = $1,000. On the other hand, if the price falls to $50 per barrel, then you would incur a loss of $1,000, as you'd have to pay to buy them at $60.

Options are very similar to futures in that they are also agreements to buy or sell an asset at a predetermined price at some point in the future. However, with options, the buyer has the right, but not the obligation, to purchase the asset. For example, you might purchase an option for 100 shares of Strabo Financial Ltd. at $60 per share. If the price rises to $70 per share, then you can exercise your option and make a profit of $1,000, as before. However, if the price falls to $50 per share, then you are not obligated to purchase the asset and so you would not incur a loss. You would have only lost the cost of the unexercised option, which would be a fraction of the price of the share. In this regard, options have much more, well, optionality, and therefore carry the same amount of upside potential with much less of the downside risk.

The option to purchase an asset at a future price is known as a call option, whereas the option to sell an asset at a future price is known as a put option. From an accounting perspective, options and futures are fairly similar: a bet on the future direction of a price. The difference comes to the customer at point of use, and the level of margin that is used. Valuation methodology is also something that differs between assets.

The benefits of trading futures and options

As you might have deduced, futures and options are a great way of making a bet on the future direction of the price of an asset. The fact that they are much cheaper than buying the asset itself means that you can use leverage to make a much larger profit (or loss) in the specified time period. One of the key reasons for this is that futures and options are traded without actually being exercised: you take the profit implicitly, rather than having to actually buy the shares on your own personal balance sheet and resell them.

Now, this is great because it means that you don't need a huge capital reserve available to make profit. Of course, the downside of this is that you have the ability to take on a level of leverage, and therefore risk, that is far in excess of your capacity.

How to trade futures and options

Futures and options can be traded on futures exchanges, such as the Chicago Mercantile Exchange (CME) or IntercontinentalExchange (ICE). These work in a similar way to stock exchanges, in that you place an order with a broker to buy or sell at a certain price. Your order is then matched with another order from another trader and the trade is executed.

It's also possible to trade futures and options over-the-counter (OTC), which means that the trade is not executed on an exchange but rather bilaterally between two traders. This is generally only done for more complex products, or where there is a lack of liquidity in the markets.

Conclusion & Tips for beginners when trading futures and options

If you're thinking of getting into futures and options trading, then there are a few things that you should bear in mind. Firstly, always use a stop-loss order to limit your downside risk. This is an order placed to exit a position and limit your losses on any one trade before they get too large. Secondly, don't put all your eggs in one basket: diversify your portfolio across a number of different assets to mitigate the risk of large losses. You can trade futures and options in not just equities, but also the foreign exchange market, and other assets. However, it's best not to just invest in these instruments but also gain access to securities through the spot market, or simply straight up making purchases of these assets. These can be done not just in one currency, but across different countries to spread delivery of risk through different markets. Retail investors now have access to much more than they used to in terms of assets, and their current prices are just one variable to consider. Know your strategy and stick to it - in low interest rate growth environments, it is easy to let this slip.

Finally, futures and options are complex products and so it's important to do your research and understand exactly what you're trading before entering into any positions. Yep, we know we keep banging on about it but it's important. The trivialisation of complicated financial products can also serve to oversimplify them, which makes them even more dangerous. There are a number of stock trading platforms which offer this service and many don't provide the adequate risk warnings to inform new users what they're getting involved in.

Futures and options are complex financial instruments and their prices can be volatile. As such, they may not be suitable for all investors. Before trading futures or options, you should carefully consider your financial objectives, level of experience, and risk tolerance. You should also consult with a suitably qualified financial advisor if you find yourself in any doubt.