If you are just starting off in investing you have probably come across the terms options and futures. These two terms are related, but also very distinct. So if you’re not sure how options and futures differ, take a moment to read this article and learn more. Understanding these important investment terms will help you as you navigate the rather complex world of investing.
Futures: Taking a Bet on the Future
Futures markets basically allow people to speculate on future movements in the market. More or less, as an investor you “bet” on which way the price for a certain asset will move in the future. You can buy a future for just about anything, from a single stock or commodity, to an entire market or index.
The simplest way to think of a future is as a contract that obligates two parties to conduct a transaction at a specified point in the future. The parties involved already agree upon the buying and selling price, as well as the expiration date. If you believe that futures are undervalued, then you would buy them with hope that prices for the given asset will rise in the future. On the other hand, if you think that futures are overvalued, and the market or asset in question will decline, you could short sell a future. As prices move, you will make or lose the difference.
Still not making any sense? Let’s illustrate how a future works by using an example. Let’s assume that you think gold futures are over-valued. A gold future with an expiration date 3 months from now is selling for USD 1,200 per ounce. However, you believe gold prices are set for a large increase. So you decide to buy a future for 10 ounces of gold.
Your intuition (or brilliant market insight) turns out to be correct. Gold prices skyrocket to USD 1,500 per ounce over the next three months. Since you bought a gold future for USD 1,200, however, you are entitled to buy your 10 ounces at that price.
With the expiration date fast approaching, you could choose to accept delivery of the 10 ounces of gold. However, generally with futures you settle in cash instead. This means that the party which originally sold you the gold would essentially refund you the money you paid, plus the extra 300 dollars per ounce. In total, you would generate a profit of USD 3,000.
Options: The Final Choice is up to You
Options are another type of speculative security. If you follow financial news, then you may have heard of executives being offered “stock options” to buy stocks at a certain price. Let’s say Microsoft hires a new CEO. The company offers him the “option” to buy up to 10,000 shares at the current selling price, $35 dollars a piece.
If the CEO does well and share prices rise, he or she will be able to cash in his option and buy stocks at a discounted price. However, if things don’t improve and stock prices decline, the company honcho will not be forced to buy the stocks. If the company had simply given him stocks, instead of an option, the CEO would lose money as prices declined.
Options are not limited just to executives. Private investors can also secure options, but they must pay for them. Investors often use options to protect portfolios against market movements. For example, if you buy 1,000 shares of Ford stocks at $20 dollars, you could buy an option guaranteeing you the right to sell them at $18 dollars. This would protect your portfolio against a dramatic decline in Ford’s stock prices. In this case, you would be using an option as a type of insurance.
Investors can use options in a variety of ways, not just as insurance. Note that both futures and options are highly speculative and thus there are high risk levels associated with them. That doesn’t mean that futures and options can’t be great investments. However, before diving into the market make sure you do your homework.