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.
Trading options is risky. While the risk is limited to the cost of the option (the ‘premium’), that isn’t necessarily small. A Google June 400 call can cost around $2800.
The premium may be only 28, but an option contract is a commitment for 100 shares. Hence the figure is multiplied by 100. Of course, for that commitment the buyer is controlling roughly $40,000 worth of stock. (‘Roughly’ since the strike price, $400, differs from the current market price, say $395 at the time of the contract.)
Options, by nature, have an expiration date. (That’s part of what makes them an option.) As that expiration date draws near the worth of that option can rapidly approach zero, depending on the current market price and other factors. Hence, risky.
And that scenario only involves controlling 100 shares – not much in the scheme of things.
One way around these difficulties is to invest instead in a fund. Funds invest in stocks, bonds, commodities, indexes, even futures or options – all the things individual investors themselves trade.
Investors who purchase a fund (a mutual fund or ‘open-end’ fund) own a portion of the instruments the funds buy. The fund is managed by a fund manager, presumably a knowledgeable and experienced investment professional. The fund manager has (in theory, anyway) the available resources, time and expertise to make investments that garner returns superior to what the individual can make himself.
The investor in mutual funds pays a fee for the service, but gets not only expertise and resources but also the advantage of being able to pool funds (hence the name) with other investors. That pooling allows control of many more shares, bonds, etc than the average individual can.
This helps influence prices in that fund’s direction. (If you don’t think so – and considering that many of them lose money skepticism is warranted – look at a chart showing price fluctuation against daily quantity bought or sold by the larger funds. There’s no question that large funds influence stock prices, which in turn can influence their fund’s value.)
For those investors interested in options, but without the time, expertise or capital to profit from them options funds are available.
Make sure you study carefully what the fund actually offers, though. There’s a difference, sometimes overlooked, between an option on or from a fund and a fund that buys options.
Some funds actually purchase options contracts and speculate just as individual options traders do. Since funds control a larger amount of capital than individual investors the ‘multiplier effect’ (leverage) of options investing is increased further.
Other funds, though, actually buy stocks and then issue options to the fund members on those stocks. That’s a different animal. This can produce profits for participants, but are more like short term trades. As the share price rises, the options are just exercised, limiting income growth opportunities.
Mutual fund investors tend to be more interested in the long-term outlook and often seek income growth funds.
The same variety of options available to the individual are, of course, there for the fund manager. Options on stocks, bonds or commodities are commonplace, but one of the newer wrinkles is options on ETFs (Exchange Traded Funds).
Funds that invest in these are actually speculating by buying an option on a fund that’s gambling on an index that measures a basket of stocks. If your head hurts – and who could blame you – maybe you should just buy stock.