Options and Futures: You Already Trade Them
A futures contract represents an agreement to buy or sell a financial product or commodity at a given price at a specified day in the future. The owner of an option has the choice to buy or sell a financial product or commodity at a given price at a specified date in the future if it would be advantageous for them to do so. The key difference between futures and options is that futures represent an obligation, whereas options represent a choice.
Both futures and options can be extremely difficult to properly value and can result in large losses for an investor; therefore, they are not always appropriate for the average individual. However, this type of investment is hardly obscure; in fact, many investors come across the equivalent of futures and options in their everyday lives, often without realizing it. In Pictures: 10 Options Strategies To Know
Floating Interest Rates
Perhaps the most common occurrence of futures and options in everyday financial life has to do with interest rates. When an individual takes out a floating rate loan, he or she is effectively purchasing an options contract on the future course of interest rates. If rates rise sharply in the future, the individual is on the hook to pay that higher rate. If, on the other hand, rates decline in the future, the individual can benefit from paying a lower rate. The individual also has the option of locking in the loan at a fixed rate at the time of their choosing. Practically speaking, this means that the individual would lock the rate on the loan if they anticipated an increase in interest rates. In this way, a floating rate loan is like an option, where the individual has the right, but not the obligation, to fix the rate of interest if it is advantageous for them to do so.
Of course, a lender is never going to give you something for nothing. Just as the purchaser of an option would have to pay a premium in order to have the right to buy or sell in the future, so too the holder of a floating rate loan has to pay for the right to fix the interest rate at a time of their choosing. This price will often be in the form of a slightly above-market interest rate, upfront fees on the loan, or lock-out periods during which the loan cannot be converted to a fixed rate. (For more on floating-rate mortgages, see Mortgages: Fixed Rate Vs. Adjustable Rate.)
An auction is another real-world example of futures and options contracts. This category has grown in prominence with the surge of popularity of EBay and other auction streams. The seller of an item on EBay has essentially sold a futures contract - he or she has agreed to sell a specified good at a specified time in the future. Nevertheless, as long as the final price meets the minimum bid, the seller is legally obligated to deliver the good as promised.
The bidder on EBay is essentially long a futures contract: he or she is obligated to buy a specified good at a specified date in the future. Unlike the seller, the bidder usually knows in advance what price he or she will pay, but is also legally obligated to complete the contract.
Betting on the Future Price of Consumer Goods
Another example of real-life futures is the behavior of shoppers during a sale. Consider Black Friday, the traditional start of the holiday shopping season. Shoppers flock to stores to take advantage of sale prices. In purchasing so far in advance of Christmas, the shoppers seldom stop to consider that they are essentially wagering that prices will not fall further before Christmas. This behavior is somewhat similar to buying a call option in the financial markets, although it is a safe bet that very few Black Friday shoppers think of it that way! (For more insight, see What is Black Friday?)
The purpose of this demonstration is not to persuade consumers to pull out a financial calculator or spreadsheet prior to heading to the mall. Rather, by recognizing the similarities between the financial markets and everyday financial transactions, consumers can better consider the true costs and benefits of these transactions. In the long run, this can help place consumers on better financial footing and, in this economy, that's definitely something worth working towards.