It’s challenging enough to get most ordinary investors to advance from putting their money in 401(k)s to buying individual stocks. Not only do the prices of the latter fluctuate more, but investing in individual stocks means decoupling oneself from the collective wisdom and movements of the market. If you lose 5% in a mutual fund, hey, them’s the breaks. Lose 40% on one stock, and it’ll make you question your decision to buy the stock in the first place, then sell in a panic, then sheepishly buy into a mutual fund with what’s left.
But millions of people do invest in individual stocks successfully, taking the time to sift through financial statements, recognize value, and then be patient. For those who indeed understand how to invest in stocks the right way, it’s only natural to want to learn more. And to benefit from leverage. As usual, the market is one step ahead of us, thanks to the invention of options and futures: second-level securities that derive from ordinary stocks and commodities, and that can lure investors by offering the potential for great returns.
An option is a contract that sets a price that you can either buy or sell a certain stock for at a subsequent time. Options to buy a stock (“call options,” or simply “calls”) differ so greatly from options to sell a stock (“put options,” or puts) that they each deserve their own explanation.
A call is the right to buy a stock at a stated price during a particular period down the road, irrespective of what the stock happens to be trading for at that time. For instance, there might exist call options for stock XYZ, each option allowing you to buy a share of XYZ at $100. If XYZ then trades for, say, $120 at any time before it expires (assuming it's American option), you can buy shares for $100, then sell them each for a $20 profit. The right to do this comes with a price, of course, and if you wanted to buy said options today, they might sell for $4 apiece or so. Some small fraction of the stock’s price.
What if XYZ is trading for less than $100 by the time you can exercise the options? Well, exactly what you think: your options are worthless, you wasted your money, and you can either try again or go crawling back to the world of mutual funds.
As for a put, you can probably surmise that it conveys the right to sell XYZ at a predetermined price at a later date. In other words, you’re hoping (or at least not freaking out that) the stock’s price will fall. If you own a put that allows you to sell XYZ at $100, and XYZ’s price falls to $80 before the option expires, you’ll gain $20 (ignoring premium paid) from trading the option. Puts are a form of insurance, saving you from the prospect of catastrophic loss.
If XYZ happens to be trading for more than $100 by the time the put ripens, it’s no skin off your nose. You don’t have to exercise options. That’s why they’re called options. Instead, you can rejoice in the realization that your stock appreciated, hopefully by more than the price of the put.
So what’s a future? More formally a futures contract, a future is a contract to sell/buy a commodity at a later date, at a price agreed upon well in advance. Like options, futures are a form of insurance. The buyer of a future would rather take the bird in the hand with a price that’s guaranteed today, rather than the possibility of two (or zero) in the bush later.
Futures originated in agriculture. Say durum historically trades for around $7 a bushel. You’re a durum farmer, and you can remember a couple of years ago when the bottom dropped out of the market and the price fell to $5. Fearing that that’ll happen again, you find a broker who promises to buy your entire harvest, once it comes in, for $6.75 a bushel. Which isn’t great, but perhaps you’ll gladly take the offer for fear of another big price drop. (If it costs you, say, $5.25 to plant each bushel equivalent, then agreeing to the $6.75 futures price could well save you from bankruptcy.) From the broker’s perspective, the idea is to lock in the $6.75 price in the event that prices rise beyond the historical average. If demand for durum increases to the point where farmers can charge $8 or $9 a bushel, the broker will profit once the futures contract closes and he can sell the wheat that he bought for below-market prices. Should the price fall, the broker will lose money. The farmer is transferring risk to the broker, simultaneously protecting himself from low prices while forgoing the chance to profit off high ones.
Since their bucolic origin, futures have encompassed more and more sectors of the economy. First energy (e.g. oil and gas), then precious metals. Futures prices for natural gas for a few months hence can differ by 1-2% from current prices, enough to make a huge difference to both seller and buyer when margins are small. In recent years, futures have even become associated with such intangible securities as currencies and stock indices. Wager that a euro will be worth so many dollars, underestimate by a few cents, and it can mean millions to the bottom line; with no risk-averse farmer or copper miner to concern yourself with. The futures market has gone from a conservative insurance exchange to something more closely resembling a baccarat table.
The other difference between futures and options is that a future is both right and obligation. When the time comes, you’re legally bound to sell or buy the underlying commodity. The exposure can be staggering. Miscalculate on a futures contract – offer $6.75 a bushel only to have the price fall under a dollar – and it can wipe a broker out.
It should be clear at this point that neither options nor futures investing is for the neophyte. But while both have risk of downside, options investing has less. An options investor is never obligated to lose more than the price of the option. Furthermore, a futures investor usually operates on a large, institutional scale. As an individual, it’ll be hard for you to find a West Texas intermediate crude oil supplier willing to sell you his supply at once. Most futures investing is thus done using the services of an established broker or Wall Street firm that specializes in engineering such deals. Meanwhile, options investing often requires nothing more on your part than the few dollars needed to buy the options. Which is still done through a firm, but it’s a lot easier for an individual investor to find underlying stock than to find agricultural or energy commodities.
The Bottom Line
Options and futures are risky. Then again, so is living on this planet. A thoughtful and discerning investor can profit from advanced investing, but not before doing plenty of research, and understanding more basic investing concepts back to front.