Buying or selling stocks or ETFs is easy. Put in a market or a limit order and wait for the trade to execute. You control the shares you purchase.
You can also control shares through futures and options, each of which has its own advantages.
What are futures?
A purchase or sale for a stock happens in real time. Futures trading is a contract to make a sale or purchase in the future. A futures contract has a buyer and a seller, both of whom agree that an asset will be bought or sold for a specific price on a specific day. The asset can be a commodity, a currency, or even an index, like the Dow Jones Industrial Index. A common use for futures contracts is to remove pricing volatility within commodity markets.
The volume of futures contracts can be an indication of where the price or index will move in the short-term, but there are some subtleties to understanding futures volume. Another element must be considered, called “open interest,” which is a measurement of how many orders haven’t executed because the price hasn’t reached the price for those orders. For example, rising volume combined with rising open interest can confirm a trend, while rising volume and a falling open interest instead suggests a liquidation.
Futures contracts are traded on futures exchanges, such as the Chicago Mercantile Exchange (CME); S&P 500 futures have the highest volume of futures contracts at the time of this writing, followed by the 10-year T-note, the 5 year T-note, crude oil, and then corn.
Futures contracts can represent nearly any index or commodity, but some indexes and commodities generate more interest and therefore more trading opportunities.
What are options?
You might remember the term “derivatives” from the 2008 economic meltdown; more specifically, you may remember “mortgage derivatives.” Options are also derivatives. A stock option is a derivative because it’s not the stock itself but rather an option to buy or sell the stock. The fact that options are called options shouldn’t be overlooked. Unlike other types of trades, there is no obligation to buy or sell the underlying security. There two types of options, allowing you to bet on either side of the trade.
A call option is an option to buy at a future date. It’s a bit like browsing at your favorite store and choosing an item for layaway — but there is a charge for putting the item on layaway. This charge, called the premium, is the cost of the options contract. It makes sense that there would be a charge because by buying the option you haven’t actually purchased the item. However, you can control that item, in this case, a stock, for a small fraction of the cost of purchasing the stock.
A put option is an option to sell at a future date. Put options can be used in various investment strategies, including a bet on a market downturn, but one of the most common strategies is using put options as a simple insurance policy. Put options can protect your downside if the market makes a big downward swing. Let’s say you bought shares in an S&P 500 index ETF (SPY) at $250. Buying put options against those shares for 10% less than your purchase price of $250 allows you to limit your loss to $25 per share if the share price dips more than 10%. Of course, you’ll have to pay a premium for this option and the option is only effective for a limited amount of time. In that regard, it’s a lot like insurance: you pay for it just in case you need it — but you may not ever need it. Also like insurance, if you want continued protection, you’ll have to renew your policy — or buy more puts in this case.
Buying an option is, well, optional. You don’t have to complete the second half of the trade, which is to buy or sell the security at the option price — and this is true whether the option is a call or a put. However, selling an option can create an obligation to actually buy or sell. Most investors are option buyers, also called call holders and put holders. Option sellers, called call writers or put writers, are the people or entities who write the option contracts and collect the premiums.
Similarities between futures and options
- No margin, no service. Futures trading and options trading require margin accounts. This doesn’t exclude IRAs entirely, but a third-party custodian for the account must be established, an extra hurdle. For retail traders, an individual brokerage account (with margin) is most frequently used, which also helps keep retirement investments separate from more exotic trades like futures or options trading.
- Insurance uses. Both futures and options can be a simple sort of insurance to either keep pricing within an understood range or to protect the downside for investment positions.
Differences between futures and options
- Contract dates affect trading. Futures contracts only allow the underlying asset to be traded on the date specified in the contract. Options can be exercised at any time prior to the option expiration date.
- Options are optional. Futures and options also differ in the requirement to make a trade. Futures are a trade — if held. In most cases, the futures contract is sold before the expiration date, preventing the trader from having to take delivery of 1,000 barrels of oil, live cattle, pallets filled with pork bellies — or whatever else is traded. Options, on the other hand, don’t need to be exercised at all. If there’s no business or investment reason to exercise the option, it can expire with the only cost being the premium for the contract.
Futures and options are similar in many ways, but often tend to be used for different purposes. A futures contract is the preferred vehicle for many active traders who want to profit from the up or down moves in the market. Because of better liquidity, bid ask spreads are usually closer with futures than with options, an important consideration when margins are slim and doubly important if you are working with a limited amount of cash in your trading account. Of course, if you have an industrial interest, futures are useful to manage costs of commodities as well.
Options are a great way to insure your investment, protecting your downside, or simply for speculation, betting on the rise or fall in an equity, index, or price of a commodity. More sophisticated options trades are also available for investors who want to combine put and call options or even create a “synthetic” position that behaves like a real holding of the underlying asset.