These instruments have a mixed reputation –– as something only for the very sophisticated investor, as dangerous, and in some circles as devices that can defy economic and financial laws. There’s an element of truth in each description except the last. I will not pretend that options and futures are simple, that they are for everybody or easy to use. But they do not require a genius mind, and, even if you never use them, it pays to have a notion of how they work.
Basically, options or futures offer you the right to buy or sell a stock, bond, or commodity at a specific price under certain conditions on a specific date or during a specific period of time. Options and futures are called derivatives because they “derive” their value from the underlying security or commodity they entitle you to buy or sell.
Futures contracts are possibly the oldest financial instruments in the world. There is evidence that they existed in ancient Mesopotamia, thousands of years before the birth of Christ. There they dealt with wheat, the ancient staple crop. Farmers planting their fields would naturally worry they would not get a good price at harvest time. Speculators would contract to pay an agreed-upon price when the wheat was harvested –– regardless of the market price at harvest time. The speculators effectively took on the risk of a loss should future market prices fall below the price they contracted to pay the farmers. That risk was worth it, however, because the arrangement gave speculators a potential profit if market prices for wheat rose above the price they paid the farmer. Thus futures allowed speculators to bet on the future price of wheat while allowing farmers to use speculators to hedge the risk of falling prices, happy to exchange the chance of extra profit should wheat prices rise high for the surety of the guaranteed price offered by the speculators.
Futures retain this basic character today, but over time they have come to include minerals, copper, coal, gold, oil, etc., as well as crops and livestock. There are futures tied to currencies and stock market indices. In every instance, the principle of the ancient wheat farmer remains the same: One party wants to hedge market risk by securing a price in the future, and the other party is willing to promise that price and take on the risk of loss in the hope of getting a higher price at that future date.
Today, futures are sold on organized exchanges for specific “volumes” of a product –– bushels of wheat, tons of copper, and the like –– with set dates when they must settle. These exchanges have rules on how much money speculators must put up to participate. Futures are bought and sold for a fraction of the amounts due when the time comes to buy or sell the underlying securities or commodities. Because the ultimate commitment in dollar terms is huge, the average individual investor seldom uses futures directly. However, many mutual funds participate in them on behalf of their investors.
Sometimes the standardized amounts and dates of expiration used on organized exchanges don’t meet the needs of large players who have in mind both different amounts and dates for settlement. They have the alternative of tailoring what are called forward contracts. Forwards work just like futures, but are organized around these different specifics. They are most heavily used in currencies, typically timed to a point where for business reasons one of the parties to the contract needs to make a payment in a currency other than their own.
Used mostly with stocks, options are more complex than futures and forwards. They come in two types:
- Calls: An investor sells another the right to buy a stock – to “call it” – at a certain price, called the strike price, within a certain period of time.
- Puts: An investor, in return for a received fee, gives another investor the right to force humor her to buy a stock at a certain strike price within a certain period of time. In financial jargon, the first investor sells to the other investor the right to “put” the stock to him.
These options are bought and sold on organized exchanges for standardized periods of time. They can vary in price, though they usually trade between 3 and 5 percent of the value of the underlying security. The financial community has worked out many strategies for them to meet specific needs or expectations. Here are two of the most common:
- Covered calls: If you own a stock whose price is almost where you want to sell it, you could sell a call, “write” in financial jargon, on that stock at a strike price a little above the current market. If the stock’s price then rises, you are just as happy to let the option holder call it, because you had already planned to sell at that higher price. In the meantime, you capture the fee on the call you sold. And if the price fails to rise, you keep the stock and the fee.
- Put escape: (This is what I call it.) If you own a stock that might become very volatile, for instance a retailer heavily dependent on holiday spending, you may want to hold it for the upside generated by a good selling season. But because you fear the downside from a bad season, you can buy a put on the stock. If the stock’s price falls, you have the option to put it to someone else at the strike price. Rather than sustain a big loss, you lose just the fee you paid for the put option. If the stock’s price rises, you can then enjoy the upside and forego the use of the put, happy to have paid the small fee on that put for the insurance against a big loss it offered in the interim.
It should be apparent that both futures and options have specific purposes for specific strategies. For that reason alone, it is mostly professional investors who use them. Because these instruments also generally involve larger amounts of money than most of us generally invest, they are far from a daily investment concern. Still, everyone should have a notion of how they work, if only to avoid feeling intimidated when they come up in conversation, and to avoid getting involved when doing so would be unwise.