Investors who want to walk on the wild side have a couple of easily accessed alternatives: stock options and futures. But which is best?
It depends, of course, on your goal, financial savvy, time constraints and stomach for risk.
“The decision between whether to use futures or options often comes down to timing,” says Gary Norden, owner of Organic Financial Group in Australia. “Futures are a much better product to day trade with, but are more difficult to hold for longer periods for retail traders.”
[See: 8 Times When You Should Sell a Stock.]
On reason: price changes in futures contracts are affected by fewer factors, depending mostly on movements of the underlying stock, commodity or index.
Either way, small investors accustomed to buying mutual funds for the long term are generally told to stay away from stock options and futures, even though it’s possible to dabble in both markets with relatively small sums, to bet on market moves or insure against loss through hedging.
Both are called “contracts” because they involve an agreement between buyer and seller to do something in the future. And each allows its owner to control a large block of the underlying stock for a fraction of the cost of the future trade.
Trading options: Where to start? An options contract gives its owner the right, for a period of days, months or years, to buy or sell 100 shares of company stock or exchange-traded funds, or shares in a market index like the Standard & Poor’s 500.
The stock options owner is not obligated to make the trade and will do so only when it is profitable. If you had a “call” contract to buy 100 shares of a company at $10 each, you would “exercise” that right and buy at $10 if the market price were higher, profiting on the difference. A “put” contract has the right to sell at a set price.
A futures contract, on the other hand, provides an obligation to buy or sell at the agreed-upon price on a specific date. The stock contract owner who does not want to complete the trade can nullify it by buying another contract to do the opposite — to sell if the first stock contract required a purchase, or vice versa.
Options trading is common with stocks and related products, while futures have traditionally involved trading commodities like grains, or precious metals or currencies. But over the years the two markets have developed a lot of overlap, so an investor can use either product to bet on a stock, the market or large portions of it, or to hedge against a market drop.
Options trading is often considered less risky because the contract owner is not obligated to spend more to buy or sell the underlying security. The trader therefore risks only the price paid for the contract — the “premium.” With no obligation, options are also more flexible, with combinations of calls and puts used in various strategies to buy stock options in a company.
[See: 10 Skills the Best Investors Have.]
“While they can both be used for hedging purposes, futures are quite a blunt instrument for that role,” Norden says. “With options we can create more targeted hedge trades that are likely to offer a better risk/reward profile and can also be held for longer.”
But he says options trading can be a good deal more confusing for newcomers, requiring an understanding of various values represented by Greek symbols. The value of an stock options contract, for instance, changes not only with the value of the underlying security but also falls as the time to expiration shortens. That’s because an stock option to buy at a given price over the next 12 months would be more valuable investment to the user than one expiring tomorrow.
Who sells options contracts? Contract values are also affected by the amount of volatility in the underlying security. If stock prices are fluctuating wildly, trading an options contract tends to be more expensive.
“Because options give you the right but not the obligation, best to use options when the outlook is less certain and when volatility is priced cheaply,” says Gwen Cheni, a hedge fund portfolio manager and former derivatives specialist at Goldman Sachs.
“Futures contracts are usually cheaper than options, particularly when volatility is expensive,” she adds. Instead of a premium, futures contracts are purchased with a small down payment on the future trade. But if the investment starts to look like a loser, the trader can be required to put more money in, a risk not present in options trading.
“Failure to post additional collateral can result in the contract closed against you at the exact worst time,” Cheni says. “If you are long an option (bought an option), the most you can lose is the premium you paid, not more.”
Why are options dangerous? With either product, the trader has to keep on top of things, to beware of rising risks and to move quickly to lock in a gain or avoid a loss. Neither is a buy-it-and-forget-it holding like a mutual fund.
Retail investors are more likely to exercise both types of contracts to speculate on ups and downs rather than to hedge, Norden says, noting that more small investors could benefit from hedging strategies.
Both options trading and futures involve a zero-sum game, with a loser for every winner. That usually means the amateur is betting against professionals.
[See: 9 Psychological Biases That Hurt Investors.]
Norden cautions that “most retail futures and options traders lose money.”
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The Difference Between Trading Futures and Stock Options originally appeared on usnews.com
