| |
What are They?
Options and futures are both very complex investments. They are classified as derivatives, meaning they are derived from other investments. They are not backed by anything as stocks and bonds are (stocks are represent ownership in the company, bonds are backed by a promise to repay). Instead, they are a bet on the future price of a security over a specific period of time. Futures contracts represent the obligation to buy or sell a specific quantity of a commodity on a certain day at a preset price. If you hold a contract to buy 5000 hog bellies and it comes due, you are obligated to buy the hog bellies. Options, on the other hand, are the right to buy or sell a specific security for a preset price during a specific period of time.
Futures and options are classified as speculative investments, but that doesn't mean that they have to be high risk. They can be used in many different ways, at various levels of risk. Some people speculate by trading in and out of the contracts, while others use them as protection against price swings in the underlying investments. Stories are told all the time about the ambitious trader who lost thousands gambling on options, but options and futures can also be a great risk management tool when used properly. Airline companies buy oil futures to protect against future price changes. By limiting their exposure to swings in oil prices, they can more accurately plan their cost and pricing structure. While futures are not an appropriate tool for most individual investors, options can be used to manage risk in stock options. For example, if an investor owns 1000 shares of a stock and wants to protect against a sharp drop, he may buy put options. Put options give him the right to sell the stock at a particular price for a given period of time. He will pay a fee for the options, which will decrease his return, but if the stock drops sharply he can avoid even bigger losses by exercising the options and selling the stock at a price higher than the market price. |
