Futures And Options: How To Hedge Your Bets And Boost Your Returns

13 mins

Futures And Options: How To Hedge Your Bets And Boost Your Returns

Mentioned in story

This pack will walk you through the world of futures and options – two of the most popular types of derivative. Don’t know what we’re on about? Don’t fret, we’re going to hold your hand while you become a pro in this (at first) complex way to invest.

What’s a derivative? They’re financial contracts that derive their value from the price of an underlying asset – most commonly stocks, bonds, commodities, interest rates, currencies and the like... Simple, right?

Not really… Can you give me some examples? Sure thing! The main types of derivatives are futures, forwards, options, and swaps.

For futures, the clue is in the name: they are agreements to buy an asset at a certain price on a defined future date. For example, I might agree to purchase 100 barrels of oil for $50 a pop, with a settlement date of March 31st. If I still happen to hold the futures contract when settlement comes due, then I’ll get a load of oil delivered to me. However, most people trading futures don’t actually want the underlying asset delivered to them – particularly if it’s a load of oil or pigs. Instead, they want to profit from the contract’s price movements before the settlement date.

Forwards are a bespoke version of futures. If a futures contract is an off-the-peg dress or suit, then a forward is a tailor-made outfit. While futures are standardized so that they can be easily bought and sold between many different people (usually on an exchange), forwards deal with more unique situations that require custom clauses.

Options give you the right to buy or sell an asset for a locked-in price. Crucially – unlike a future – an option doesn’t oblige you to make the purchase if it’s no longer a sensible financial decision. So if you own an option to buy a stock for $40 but those shares are currently trading at $30, you can just go and buy the stock in the open market instead of exercising the option. But if the stock price climbed to $50, you could exercise your option to buy at $40, sell at $50, and make a profit.

Swaps allow two parties to sign a bespoke, mutually-beneficial deal. For example, Company A might want to borrow a large amount to be repaid in 30 years, but is struggling to get a good interest rate for that length of time. Instead of settling for a poor rate, they agree a deal with Company B, who is currently able to borrow much more cheaply over that timeframe. Of course, Company B will benefit for its trouble.

Why should I care? Derivatives at first might sound complex and obscure, but basically everyone trades them: every bank, all governments, and most large companies bet on future prices. The derivatives market is epically huge – bigger than all other financial markets combined.

However, the derivatives market isn’t only reserved for the aforementioned financial giants. Small retail investors (the likes of you and me), can try their luck too. Plus, to make life a little easier, we only really need to worry about futures and options. In the next session, we’ll tell you all about the former.

What Are Futures?

How do futures work? Ironically, futures are the oldest type of derivative – with a history stretching back well over a century. Originally these contracts allowed farmers (and merchants buying large volumes of crops) to lock in the price of produce, to hedge against sudden changes in supply or demand.

However, pretty quickly people realized you could also use these contracts to bet on the price movements of commodities like wheat or corn – which is basically what we still do today.

Aside from produce, what other markets have futures? Over the years the contracts have spread. In the modern world of high finance there are futures on pretty much any market you can think of – from company stocks to oil to currencies. Futures on the S&P 500, the benchmark index for US shares, were launched in the 1980s. They open for trading several hours before the “regular” stock market and close later, allowing you to place bets on the direction of American shares early in the morning or late at night.

Why are they so popular? Futures allow you to take a punt on the price of an underlying asset, without having to own it. Very few traders actually want to handle thousands of tons of pork – it gets a bit messy. Plus, when you buy futures on the S&P 500 (or the Euro Stoxx 50 in Europe) you can buy or sell pretty much the whole stock market in just one transaction, saving you from messing around with shares in single companies.

What are the risks? This is where it gets dicey because futures allow investors to easily take on extra risk by amplifying their bets with money borrowed from their broker. This leverage can be useful if you want to make a decent short-term profit from a bet that (for example) oil will rise, when its price generally only swings by a percentage point or two every day. But it also means that if you end up on the wrong side of a bet, your losses can snowball quickly. This brings us onto the concept of margin.

What’s that? Margin is basically the down payment you have to make in order to enter a trade. While plenty of brokers will allow clients to trade traditional stocks “on margin”, with futures the margin can be much lower – around 5-10%. These highly-leveraged trades can lose you a lot of money very quickly.

Let’s imagine you’ve used a slim margin (that’s a small down payment) to buy futures on the price of wheat. If the price of the contracts falls, your down payment will be rapidly eroded. If it gets too low, the exchange (where buyers and sellers are matched) will come knocking, asking you to deposit more cash. If you’ve run dry, you may well be forced to sell your position and cut your losses. This dreaded “margin call” has become a Wall Street cliché – it’s even the title of 2011 movie starring Demi Moore and Jeremy Irons.

In conclusion: futures open up a world of investing possibilities – but can be incredibly risky. As a small investor it’s probably easier and safer to steer clear of them entirely. But there are certain markets – mainly commodities – where futures are the main way of participating.

Now on to options.

What Are Options?

Time to talk options. Like most derivatives they’re simultaneously very simple and very complicated. Let’s deal with the simple stuff first.

As the name suggests, an option gives you the option to buy or sell an asset (stock, bond, barrel of oil, pork belly, etc.) at a certain price. The major difference with futures is that owning an option gives you the right but not the obligation to buy or sell. If you own an option you can always just walk away and let it lapse – and all you’ve lost is the money you paid to buy the option.

Options that give you the right to buy are known as calls and those that give the right to sell are known as puts.

Can you give me an example? Let’s imagine Apple shares are trading at $200. If you think they’re going to climb you could simply buy the stock and sit and wait. But it might be cheaper to buy a call option that gives you the right to buy Apple stock at, say, $210. If the share price rises above $210, you’ll be quids in (factoring in what it cost you to purchase the call in the first place, of course).

And how about puts? If buying a call is a bullish bet on a stock rising, buying a put is a bearish hedge against the price falling. As you might have already guessed, owning a put option gives you the right (but not the obligation) to sell at a certain price. For example, if you owned Apple shares trading at $200 and became worried the price would fall in future, you could purchase a put giving you the right to sell at $195. This way, you would cap the amount you could lose on your Apple holdings to just $5 a share – though of course, because there’s no such thing as a free lunch, you’d be paying a certain amount for the protection the put option offers.

Any other jargon I need to know? Just a couple more… Apologies! It’s very hard to talk about derivatives without using these technical terms. When a trader makes use of an option, they’re said to be exercising it. And the price at which an option gives the owner the right to buy or sell is known as the strike price.

In the example above, an investor would be buying Apple puts with a strike price of $195.

An option that would currently be profitable to exercise is described as being “in the money,” while those that are currently not worth exercising are “out of the money.” Those on the knife edge between these two states are called “at the money.”

How much does it even cost to buy an option? Prices fluctuate and are driven by three main factors. The first is the difference between the strike price and the current price of the underlying shares, barrel of oil, or whatever. Obviously an option to buy Apple shares for $200 will be worth more if Apple is currently trading at $250 than if it’s trading at $201.

The second factor is volatility, or how much prices are likely to swing up and down in the near future. If traders think Apple stock will remain steady around $200 for the next few months, they won’t be as keen to pay up for the protection options can offer. However, if they think Apple stock will swing wildly between $150 and $250, options will be a more attractive purchase and their price will rise accordingly.

The final major influence on the price of an option is the time to expiry. If Apple stock is currently at $200, you’d pay far more for a call option with a $250 strike that expires 10 years from now than one that expires tomorrow.

Feel like you’ve still not cracked how options are valued? Don’t worry we’ll look more closely at how options traders think about valuing options soon.

Now on to how professional investors use options in real life.

Trading Options

Strap in, because it’s time to get even deeper into the world of options contracts.

Just as you can buy and sell a stock or a bushel of wheat, you can both buy and sell options. Buying options is relatively low-risk: the worst that can happen is the option becomes worthless and you lose the money you spent buying it. But the act of selling options can lead to massive losses if the price of the underlying stock moves against you. Uh oh.

How does that work? Someone selling an option pockets the price of the option and hopes it will never be exercised. So if you’re selling a call option you hope the price of the underlying stock will fall and if you’re selling a put you hope the price will rise. Confused? Don’t worry, we’ve got an example.

Is that all? Not yet. In real life, investors will often combine purchases and sales of different puts and calls with different strike prices or durations to create complicated bets on the future price movement of the underlying asset. These combination trades can have odd names like collar, iron condor, or even seagull spread.

To give you a couple of examples: if you thought a stock was likely to have a big price movement in the future, but you weren’t sure whether that movement would be up or down, you could buy both a put and a call on the stock (with the same strike price). That way if the stock falls dramatically, you can exercise the put and make money. At the same time, if it climbs you can exercise the call and profit that way. All you’ve lost is the money you had to pay for the two options. This fairly common options strategy is called a straddle.

Since it can be hard to visualize the conditions under which these more complicated options trades will lead to profits or losses, investors often create little graphs.

This chart illustrates the straddle strategy we just mentioned:

straddle
straddle

And this is another simple strategy, called a bull call spread, where the trader buys calls while selling the same number of calls with a higher strike price:

bull call spread

Don’t worry, you don’t have to faff around drawing graphs on paper. Many online platforms, like Optioncreator.com, will include tools where you can build and analyze options trades.

In both graphs, the straight lines illustrate the potential profits or losses at expiration of the options. If you’re curious, some platforms will also calculate these values in the days and weeks leading up to the contracts’ expiration. These generally come out as smooth, curved lines rather than straight ones.

”The Greeks": Assessing Options

When you purchase an option (or sell one, if you want to live life on the edge!) all you can choose is the strike price and expiration date.

Can you remind me what those things are? The strike is the price at which you can exercise the option, and the expiration date is when the option ceases to be valid. With US-style options the holder of the option can exercise at any time up until expiry, but with European-style options you can only exercise on the expiration day itself.

Sounds simple enough. What else should I worry about? Sadly, trading options gets complicated quite quickly – even if you’re not trying to implement a complex strategy. These two variables of strike price and time until expiry combine in intricate ways to affect the price of the option (and hence the value of your investment) at any time.

Traders have named these effects after Greek letters. We’ve explained the main ones below:

🔷 Delta: a measure of how much the price of an option will change with a movement in the underlying stock. When the option is well “out of the money” and very unlikely to be exercised, then delta tends towards zero. It doesn’t really matter what happens to the stock, as only a huge move would ever give the option any value. And when the option is very likely to be exercised (a.k.a. “in the money”) then delta tends toward 1 – buying the stock and buying the option are basically synonymous so their prices move in lockstep. When the stock trades near the strike price, delta is usually about 0.5.

🔷 Gamma: the rate of change of delta, which gives an indication of the stability of the current price of the option.

🔷 Theta: gauges how quickly an option will lose value with each passing day. An option is inherently more valuable a long way from expiration, because there’s more chance it’ll end up “in the money”. So if you’re holding options over a long period, be aware that – all else being equal – their value will steadily depreciate.

🔷 Vega: the measure of how much the option’s price will change with a given shift in the underlying stock’s implied volatility.

Most trading platforms will automatically calculate these values for you, but be aware that they’ll change all the time. And a change in one can feed through to the others.

But how do I actually buy or sell an option or a future? You’ll need to open a brokerage account.

A word of caution: option prices have the potential to swing around violently, even with quite small moves in the underlying stock, bond, or commodity. And selling an option can leave you on the hook for immense losses. Don’t lose your shirt!

Finimize

BECOME A SMARTER INVESTOR

All the daily investing news and insights you need in one subscription.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

/3 Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.

Finimize
© Finimize Ltd. 2023. 10328011. 280 Bishopsgate, London, EC2M 4AG