How To: Options & Futures Analysis

Options and Futures

·       These trading products are similar in that they provide investors with an opportunity to make profits and to hedge investments.

·       Futures contracts oblige an investor to buy an asset, and the seller is contracted to sell and deliver the asset at a specified date in the future except if the holder’s position is closed before expiration.

·       Options contracts give the right but not an obligation to an investor to sell or buy shares at a set price at any time while the agreement is in place.

Options and Futures are financial products. Investors use them to make profits and to hedge their existing investments. Both of them permit an investor to buy an investment at a specified price by a particular date; however, the markets for the products vary in how they work, also in how risky they are to an investor.

Options

These are known as a derivative form of investment. Options are offers to buy or to sell shares but they do not signify ownership of the underlying investment until the agreement is exercised.

Options do what they say; they provide an investor with the option to purchase or sell an asset at a specified price while the contract is in effect. Investors are not obligated to sell or buy if it is not in their interest to do so.

These contracts attract a premium of 100 shares of the underlying asset. The premiums usually represent the ‘strike price’, also sometimes known as the ‘exercise price’. It is the set price for which the contract can be sold or bought when it is exercised.

There are two types of options, Call and Put.

·       Call options – the strike price is the price at which the security can be purchased.

·       Put options – the strike price is the price for which the security can be sold.

Futures

With a futures contract, the obligation is to either buy or sell an asset at a price that has been previously agreed. These contracts are ‘hedge investments’ and are most commonly associated with commodity trading such as with oil, sugar or wheat.

An example is where a farmer would be guaranteed a price for a wheat crop that would be payable even if the market crashed before the product was ready to be delivered. Conversely, the buyer of the wheat could benefit significantly if the market price for the commodity was to increase for some reason – perhaps a failure in one of the major wheat-growing countries of the world. He would then be buying the wheat cheaply and selling it on for a handsome profit.

Futures markets are now a feature of the stock market. Individual stocks can be bought with ‘stock futures’ or on an index such as the S&P500. A buyer does not have to pay in full upfront, just a percentage, called the ‘initial margin’ is payable.

Institutional buyers

Futures were created for institutional buyers who take possession of a commodity to sell it on. Agreeing on a price in advance works well for those on both sides of the contract because it protects both buyer and seller from wild price swings in the market.

Retail buyers

Retail buyers differ in that they buy and sell the contracts, in effect, to bet on the direction the price of the underlying security will take. Their profits are made when changes in the price of a future go up or down. Such buyers never take possession of the products.

The risks

As with all investments, there is an element of risk involved. For an individual investor, futures are riskier than options. There is typically a large amount of money involved and the obligation attached to futures to sell or buy at a set price makes them particularly risky ventures.

With a futures contract, there is a maximum liability for both sides, buyer and seller. As the price of the underlying security fluctuates either of the parties to the agreement might be required to deposit cash into their trading account to fulfil a ‘daily obligation’. The reason for that is because gains on the position of a future are input to the market each day. The result of that is the value of the position, whether it goes up or down, is at the end of each trading day passed to the accounts of the parties involved.

Options can be complicated investments and they are regarded as being risky by nature. With a stock option, the only liability attached is the premium cost; however, if a put option is opened, the seller is exposed to the maximum liability of the underlying price of the stock. For example: if the put option gives the buyer the right to dispose of the stock for a price of £100, but the price of the asset drops to £50, the initiator of the contract must buy the stock for the agreed amount of £100.

Conclusion

Options and futures are best left to the professionals. They are complicated investment vehicles and a thorough knowledge of how they work and the markets is essential to avoid losing a lot of money.

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