Options & Futures Markets
Investors have choices when choosing to invest in financial securities. The options and futures markets offer investments in securities based on the future. The investor's ability to guess what might happen in the future can pay off in profits to the investor. Options are used to reduce the portfolio risk from speculative investing. Futures are riskier than options but have the benefit of higher returns. In the end, the investor may decide to reduce the risk of futures and options by using managed accounts similar to mutual funds. The knowledge of the market and risk will ultimately determine the success of the investor in futures and options. However, the ability of the investor to weather volatility, tolerate risk and invest for the long term is directly tied to whether or not success will be realized.
Keywords Arbitrage; Bear Market; Bull Market; Derivatives; Futures; Futures Contract; Margin Call; Mark to Market; Market Order; National Futures Association; Offer; Option Contract; Options
Futures and options are financial instruments that focus on the future. Options give an investor the right but not the obligation to purchase a financial instrument at some time in the future (Kansas, 2005). Futures are contracts between two parties that give the buyer the right and obligation to purchase a financial instrument at some time in the future. Options giving the right to buy are called "call" options. Options giving the right to sell are called "put" options (Faerber, 2006). Futures can be any type of financial security including stocks, bonds, stock indexes, currencies, and commodities such as oil, coffee, orange juice, soybeans, gold, silver, pork bellies and corn. According to Ira Krulik, C.O.O. of New York Portfolio Clearing, “Options and futures and futures do walk hand in hand; most traders are trading these two interchangeably and simultaneously" (Timberlake, 2011).
Options and futures are traded at financial exchanges. Options are traded at the Chicago Board Options Exchange (CBOE) using brokers and market makers (Faerber, p. 51, 54). Market makers are firms that buy and sell stocks for their own stock inventory while brokers are companies that sell stock on behalf of financial institutions and the general public. The CBOE is the largest options market in the world. The Philadelphia Exchange is a regional exchange that lists options. The Chicago Mercantile exchange lists futures and options while the New York Mercantile Exchange lists futures.
Groz (1999) reviewed five categories of investments including stocks, mutual funds, bonds, options and futures. All have different benefits and disadvantages.
- Options are used to reduce portfolio risk from speculative investing.
- Futures are riskier than options but have the benefit of higher returns. It is also possible for investors to reduce the risk of investing in futures by using managed accounts which are similar to mutual funds and balance out the risk of investing directly in futures. However, as with any managed account, the investor has to be certain that the fees associated with the account are warranted when compared to the long term returns of the account.
Groz (1999) likens options to bonds in that they have a specific, date-driven end point. For bonds, this ending point is a maturity date. For options, the ending point is expiration date. Godin (2001) stated that the seller is the party who determines the expiration date and the price at which the buyer can exercise their option called the strike price. The strike price is only valid, however, if the buyer exercises the option before the expiration date. From this example, it is easy to see how dependent options are on time and how volatile options can be. An investor can make a decision that is based on the best knowledge they have available today. Yet, in an instant — as soon as the next day — the buyer may find that market conditions have changed dramatically. Godin (2001) found the "premium" or price of options to be dependent on the market demand, current stock price and the time that remains before the option expires.
Options have benefits and drawbacks as an investment. Godin (2001) referred to options as the right to buy or sell stock at a certain price. Godin noted that many investors aren't really interested in buying or selling the stock their option is based on. Instead, they use the buying and selling of the options as the investment. The downside is option volatility or the propensity to go up and down rapidly. However, when used optimally for the investor's benefit, they can be used as a hedge against risk in the investor's portfolio.
The way buyers make money on options depends on the decisions they make about time and selling the option. For example, a buyer purchases an option to buy called a call option. The option is purchased at a specific expiration date and strike price. If the price of that stock goes up, the buyer has some choices to make. The buyer can exercise their right to buy shares of the stock represented by the option. They can then sell the stock they purchased at the higher price since it has gone up in the market. So the goal of purchasing call options is that the stock price will rise higher than the strike price of your option. Sell options or put options work in a similar way but in a different market direction. You may purchase a put option on a stock that you expect to fall in price. If the price of the stock falls below your strike price before the option expiration date, you can exercise your right to sell shares at a higher price, thus making a profit.
Options offer no advantage to investors if the underlying investment, stock for example, is at the same price as the strike price because the investor can neither buy nor sell to make a profit. When an investor closes their option position, they are selling their options back to the open market in order to make a profit (Godin, 2001). Ultimately, Godin suggests that the ability to enjoy investing in options or any risky investment vehicle is directly related to how well the investor can tolerate risk and rapid changes in the market. If the investor is fearful of bear markets when prices are decreasing and often doing so rapidly, it is likely that the investor will choose to liquidate the falling investments at a loss. Similarly, Jones (2006) described a long-running bull market where prices are rising. Just as a bear market might instill fear in the investor, a bull market might instill false confidence. Knowing your own ability to tolerate risk and need to avert risk can be valuable in determining the appropriate investment strategy. Investments in stock are usually for the long term but risk averse and small investors often don't have the wherewithal or the ability to tolerate periods of downturn.
The basic question investors must ask themselves about options is how confident are they that a specific situation will occur in the future. Kansas (2005) notes that options are less risky than the actual stocks themselves because the most an individual might lose in a day of market activity is the initial investment made. However, Kansas also describes options investing as "complex and risky" requiring the investor to have education and knowledge of risk and somewhat intricate mathematical abilities. Kansas recommends options only for seasoned investors and suggests part time investors stay on the sidelines. The most volatile period for options based on stocks is the “triple witching” session once a quarter on the third Fridays of March, June, September and December when most stock options expire on the same day (Kansas, 2005). Volatile periods are also times to avoid for novice investors.
Types of Options
Options are generally purchased with expiration dates of no more than a year away and often expire monthly. Other types of options include long term options, index options and futures options.
- Long term options, as the name implies, allow the investor to purchase options with expiration dates farther into the future.
- Index options are based on indexes such as the Standard and Poor's 500.
- Futures options are complex options based on futures where the option itself is not an obligation to buy, but the underlying futures contract does have the obligation.
Strategies for Buying Options
Groz (1999) explains that options contracts require a relationship between the buyer and the seller called a "zero-sum game" meaning that one person wins and the other person loses. If you profit, the other player experiences losses. However, even if a player experiences a loss, the transaction may provide value to the player by reducing risk, improving the relationship between assets and liabilities, creating a position in the market or other benefits. Groz suggests five strategies called "combination strategies" that investors can use for options:
- Buy stock and buy put: For situations when...
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