Blackberries. iPhones. Personal digital assistants. These gizmos keep us in touch and on time. The investing world has its gizmos, too. They're called derivatives.
Derivatives are so named because their price is derived from the price of something else, such as a stock or a commodity. Just as tech gizmos have proliferated over the past few decades, so too have the number and variety of derivatives. Most fall under one of two basic types: futures and options.
This lesson will cover how futures and options work, and help you determine how these very risky investments may work in your portfolio.
What are futures?
A future is a contract that says that the buyer will purchase a specific item for a specific price at a specific time in the future. Such contracts were originally used as protection against price volatility by buyers and sellers of commodities such as grain, oil, and precious metals.
For example, a farmer planting a wheat crop in May could lock in a fixed price for his September harvest by buying a wheat futures contract. That way, he's protected if the price of wheat falls. Of course, he also misses out on the benefits if the price of wheat rises.
By far the most popular futures these days have nothing to do with actual physical products. Rather, they're used to speculate on the direction of interest rates, currency exchange rates, and stock-market indices.
These financial futures do have their practical uses. Most companies doing business overseas use currency futures to hedge against fluctuations in the value of the pound. Individual investors can use futures, too, to hedge against risk, or to place a bet on the strength of an index, currency, or interest rates.
Speculating in futures is not a good idea for most investors, though, for a number of reasons. For one thing, futures are a zero-sum game; for every pound of profit you make on a future, the person on the other end of the contract loses a pound. That means that your chances of losing money are greater than with stocks or funds, which can grow without anybody losing out.
Even more important, because they require an investor to put up only a fraction of the contract's value, futures allow much greater leverage than other types of investments. That's what makes playing the futures market so dangerous. Whilst huge gains are possible, huge losses are equally so.
Options
Options are much like futures, with one important difference: An option gives its owner the right, but not the obligation, to buy or sell a specific item at a specific price (the "strike price") over a specific span of time. The owner can choose when to exercise an option, or he or she can choose not to exercise the option at all. The option then expires worthless, and the investor's only loss is what he or she paid for the option. Thus, options have less downside risk than futures.
When most people think of options, they think of the stock options issued by companies to their employees--the kind that made millionaires out of a few lucky souls working for hot technology companies in the late 1990s. Such options are generally not transferable (except to the owner's immediate family), and they can be exercised over a period of up to 10 years. Since these options can't be traded, the main decision their owners face is when to exercise them.
What we're concerned about here, though, are options that are publicly traded. Anybody can buy or sell such options, and these options expire after a much shorter period--usually three months. Most publicly traded options are for individual stocks, but there are also options on indices such as the FTSE 100.
There are two types of publicly traded options: calls and puts.
A call option gives you the right (but not the obligation) to buy a stock at a specified price; you would buy calls if you think a stock's price will rise. A call option is in the money if the share price of the stock is above the strike price.
A put option gives you the right (but not the obligation) to sell a stock at a specified price; you would buy puts if you think a stock's price will go down. A put option is in the money if the share price of the stock underlying the option is below the strike price.
Calls and puts may not be as risky as futures--because you're not obligated to do anything, your greatest loss will be the loss of the cost of the call or put. But options are leveraged on the upside. For example, buying call options requires far less outlay than buying stocks would.
Yet calls and puts are inappropriate for most investors, too. Why? Because few investors make money with options. In fact, 80% of all options expire worthless. Even if you're buying puts to protect your portfolio, you're still betting on the direction of a stock's price or the market during a specific period of time. That's not investing--it's gambling. And for the majority of investors, it's not profitable.
Using futures and options in a portfolio
But maybe you're the gambling type. Or you think you'll be one of the 20% who can invest in options profitably. How might futures and options work in your portfolio?
Suppose you have most of your portfolio in diversified funds, but you've set aside a small amount of money to test your stock-picking prowess. If you buy call options rather than the stocks themselves, you can benefit from rising prices without laying out nearly as much cash. Of course, you could still lose money if the stocks go down, but at least your losses are limited to the price of the calls.
Or suppose you own a portfolio full of FTSE 100 stocks, and you're convinced that a market downturn is imminent, but you don't want to sell your holdings and incur taxable gains. You could sell FTSE 100 futures instead. Index futures contracts move in step with the underlying indices, so if you're right and the index falls, you can buy back the contract for less than you were paid for it in the first place--you make a profit. Even though the stocks you own have gone down, you've tempered that loss with a profit from your futures.
Of course, that's if you're right. And if you're like most investors, you probably won't be. Take it from us: Most investors will do just fine without ever buying or selling futures and options.
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