Futures & Options Trading Basics

[Admin]

Investors who want to become more active traders often look to futures and options as a way toward a quick profit. Both futures and options offer a way to get involved in a market sector and the potential for profit without the need for long-term investments or a large input of cash up front. As with all investments, however, futures and options traders should educate themselves thoroughly before trading to achieve the best results.

Derivative Securities
Both futures and options are derivative securities, which means they are contracts related to the current and future price of a stock, bond, commodity or currency. Traders in derivatives are speculators who buy and sell these securities in anticipation of price changes within the market. The advantage of derivative trading is this relationship to price. Because a contract can bet on a price going up or down, a savvy trader can make money regardless of the overall market direction.

Futures Contracts
The most common futures contracts are agreements between two parties to trade something --- typically a commodity or currency --- for a particular price at a certain point in the future. Originally, these contracts were created between farmers and manufacturers for the sale of crops and herds. For example, a sheep farmer might agree in January to sell 100 bales of wool to a blanket manufacturer in May for a certain price per bale. Now, futures are traded on dozens of things, such as grains, oil, precious metals, stocks, bonds, indexes and currencies, and actual buyers and sellers are joined by dozens of traders who never see a bale of wool or barrel of oil.

Types of Options
Options are similar to futures contracts in that they are the right to buy or sell an asset for a particular price. The difference lies mainly in the contractual obligation of the trader. With futures, both buyer and seller have the obligation to make the trade if they hold the contract on its expiration date. With options, the option holder is not obligated to trade, but the option writer is obligated to buy or sell if the holder decides to exercise the option. Options come in two forms: puts and calls. Puts are the right to sell a certain number of shares at a certain price, while calls are the right to buy.

Trading
With both options and futures, traders bet on changes in the market price of the underlying asset. For example, consider a trader who buys a call option on XYZ stock for $50 per share. This option gives her the right to buy shares of XYZ stock at $50 any time between now and the expiration date. During that time, the option holder hopes that the price of XYZ stock will go up. If the price reaches $60 per share, the trader can exercise the option, buy 100 shares of XYZ for $5,000, then sell them at the market price of $6,000, pocketing the $1,000 difference --- less the price of the options contract --- as profit. Futures and options contracts are significantly cheaper than buying and selling the assets themselves, so traders can make a significant amount of money --- or lose only a little --- without a large initial investment.

Attachments

future-option-basics.ppt (497 Kb) Downloaded 925 times