Options – Futures – Risks and Advantages

The terms ‘options’ and ‘futures’ appear together often enough to confuse even knowledgeable traders into thinking they are the same thing.  But, while they have important similarities, options and futures are distinct trading instruments.

An option is a contract conferring the right to its buyer to purchase an underlying asset at a fixed price (the ‘strike price’). The right – not the obligation. A futures contract, by contrast, obligates the buyer (the ‘long position’) to purchase and the seller (the ‘short position’) to deliver some asset by a set date.

That underlying asset, in either case, can be a commodity (such as wheat, oil, gold), shares of stock, or some more nebulous instrument such as an index. Since an index is just a number no physical delivery is possible, such trades are settled in cash.

Futures have value as a mechanism for trading risk, publishing prices, and (like options) taking speculative advantage of leverage.

A farmer may not know in April precisely how much wheat he can deliver. Insect damage, droughts and other kinds of crop failure are even today very much real supply problems. Similarly, he can’t predict in April exactly how much demand will exist in October. (In part, that depends on the supply.)

Selling a futures contract allows him to offload that risk to someone willing to bear it. He obtains a set price commitment today in exchange for a promise to deliver a good by a certain date in the future. On the other side of the contract, the buyer offers a promise today to accept delivery of the good in the future.

Neither knows with certainty what the market price will be on the expiration date of the contract, only what the market price is on the day it’s entered.

For the contract buyer, a future offers several values in exchange for accepting the obligation to take delivery of (and pay for) a set amount of goods at a pre-set price.

One major value is, as in the case of options, the use of leverage. While options require paying of a premium (usually around 5%-10% of the current market price), futures have no in-built cost (apart from a small commission).

The buyer is required, though, to put up a ‘good-faith’ deposit, also in the neighborhood of 5% of the total. But that margin deposit allows the trader to control 10-20 times the amount of good he would otherwise have to pay for. That ‘multiplied control’ is leverage.

[Note: Though it’s called a ‘margin’, it’s NOT the same as buying stocks ‘on margin’. In the latter case, that is a form of borrowing – with the broker lending the trader the amount needed to purchase all the shares the trader then owns.]

As a practical matter, a very small percentage of futures contracts actually result in the buyer accepting delivery of, say, 1000 barrels of oil. While the behind-the-scenes mechanics are somewhat complicated, at expiration the goods are ultimately transferred to brokers who sell them to those who actually make use of them.

To the traders the exchange is simple, though. Any change in prices is reflected in the accounts of the trading partners at the end of each day’s trade. At some point the contract is either sold (the most frequent result) or expires.

Trader Psychology

Professional athletes are often told by their coaches that their attitudes on the field can affect whether they win or lose. That’s even more true in Forex trading. It sounds like the standard motivational speech, but having the right frame of mind can definitely influence your trading results.

There are many aspects of Forex trading that are outside the investor’s control.

Forex market participants number in the millions – traders for the world’s largest banks, huge governments and individuals just like you. Unlike stocks, even the big traders have a tiny effect on exchange rates.

Even when setting interest rates and other actions that influence inflation, the largest governments can have no immediate impact on exchanges. The Forex markets are simply too large – $2 trillion daily – for any one player to dominate the action.

Trading strategies, which are essential, can increase the odds of making profits and help minimize or avoid losses. They give the knowledgeable trader that tiny edge that can make the difference between winning and losing on a given trade, or over time.

But before looking at market influences, and even before developing a set of technical strategies that help guide trading choices, the novice Forex investor has to honestly and objectively examine his or her own attitudes.

Forex is fast-paced, complicated and requires a well-thought out game plan. That game plan has to be executed with nerve and skill. Trading successfully in a demo account for several weeks is essential but can lead to unwarranted confidence. Traders who invest Monopoly money will often take chances, leading to successful trades, that they wouldn’t dream of taking with real money.

Real trading requires answering honestly a number of questions that can be difficult to answer objectively when the subject is the self-same trader asking them. What are your financial trading goals? Looking for a quick buck? Seek elsewhere. You will have losses that wipe them out. Looking for secure, low-risk capital accumulation? Try AAA bonds instead.

Forex trading can be simultaneously a stimulating intellectual game and an exciting adventure. The thrill of victory! The despair of (temporary) defeat! The mastery of the intricacies of Fibonacci, Parabolic SAR, Stochastic Oscillators and Doji Stars. All this, and much more, is part of Forex investing.

As a result, you will need to be very frank with yourself and decide how (and whether) you are prepared to deal with pressure and fear. Even professional traders do not have any certain system of ensuring profits and avoiding losses.

The pressure of deciding when to buy and when to sell is many times larger than in stock trading. The fear of loss is greater, in part because of the amplification provided by 100:1 or larger leverage.

Even winning can be problematic. With practice and persistence, provided you don’t quit too soon or run out of money too quickly, you will have periods when it all seems laughingly easy. That can lead to euphoria, which is great. But it can also lead to cockiness, which is fatal. Nothing will wipe out a trader quicker than arrogance. Confidence is essential, vanity is suicidal.

The other side of the coin to be avoided is too much second guessing. Successful trading requires bold moves based on sound judgment and confidence. Every decision is a small leap of faith, since no one can know in advance for certain what the outcome will be. Probability of one degree or another is the best that can be achieved.

All this will be accompanied by the fear of loss of capital, which often leads to panic selling in the face of what would have been a temporary price movement. It is of such panics that depressions are made, both economic and psychological.

Forex is a roller coaster ride. But if you have a good inner ear and a strong stomach, bolstered by the brain of a statistician and the nerves of a pro billiards player, you will be well suited to end the ride with full pockets.

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