Forward Diary

How to Trade Futures & Options

Among the oldest of trading instruments, futures contracts were initially set up to enable producers and buyers of goods to agree a price today for delivery in the future. Futures have their roots in agriculture, although the market has grown dramatically and they are available today on a whole range of financial products. This includes individual shares, stock market indices, currencies, bonds and interest rates as well as commodities. A futures contract is simply an agreement between two parties to buy and sell a particular product on a certain date at an agreed price. The basics of trading are simple: if you believe the value of an asset is likely to fall, you sell it, and buy if you think it will rise. Futures are highly leveraged. A trader only has to put up a fraction of the value of the contract, usually around 5-10%, as margin, and if he has predicted the market movement correctly his profits will be multiplied accordingly. If the contract incurs a loss, this will be deducted from the initial margin, while profits will be added to it. If the loss exceeds the amount of money in a trader’s account, he or she will receive a margin call for more funds to be deposited. As with other instruments, though, traders can usually control their risks by placing stop loss, trailing stop loss and limit orders.
 Futures trading is a cost-effective way of participating in the market. Brokers are reluctant to divulge what they charge but the bigger your trading account, the better the deal you are likely to get. Enthusiasts point out that with futures you are dealing with a regulated exchange, which means that you are guar- anteed best execution and transparency of prices. Trading is carried out through some of the world’s major futures exchanges, including CBOT, CME, Liffe and DTB. Futures do not track the price of the underlying asset as closely as CFDs, say, but are defined instead by the prices of the futures market for the particular instrument. Liquidity in futures markets can pose problems for traders due to the fact that exchange-traded futures require exactly matching buyers and sellers. This sometimes results in the market maker being called to fulfil an order, leading to higher pricing. Futures contracts can be used in many different ways, depending on your investment objectives. The obvious way is to profit from volatile market conditions by going long if you think a market will rise and short it if you think it will fall. But you can also use futures to safeguard or hedge your existing underlying assets if you believe the price will fall. This can be done, for example, by selling futures against an equity portfolio to avoid making a loss, without having to incur the costs associated with selling your holdings. Traders need to be aware that there is an issue regarding physical delivery of the under-lying asset or security on expiry. With futures, both parties are required to fulfil the contract on the delivery date. That doesn’t necessarily mean that if you buy a crude oil future, for example, barrels of the stuff will be deposited on your doorstep, but you will need to ensure a contract is closed before expiry. If you don’t close a position, it is likely the trading plat- form will close it for you automatically at the current market rate, passing any gains or losses on to you. Opening a futures account is a relatively expensive business. For example, a typical minimum deposit for an electronic trading account is around £5,000-10,000. Comparing futures brokers via their websites is not a straightforward business – they tend to be guarded about how much information is publicly visible before you register - but it is essential to compare accounts, trading terms, research tools and training aids before going too far. Options An option is a contract to buy or sell a specific financial product, officially known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on, and it has an expiration date. When an option expires, it no longer has value and no longer exists. Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices - whether to buy or sell and whether to choose a call or a put - based on what you want to achieve as a trader. If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you generally have the right to sell the option to another buyer during its term or to let it expire worthless. When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn’t fixed and changes constantly - so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there’s agreement becomes the price for that transaction, and then the process begins again. What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that’s determined by whether or not the option is, or is likely to be, in-the- money or out-of-the-money at expiration. A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless. Several factors, including supply and demand in the market where the option is traded, affect the price of an option, as is the case with an individual stock. What’s happening in the overall investment markets and the economy at large are two of the broad influences. The identity of the underlying instrument, how it traditionally behaves, and what it is doing at the moment are more specific ones. Its volatility is also an important factor, as investors attempt to gauge how likely it is that an option will move in-the-money. Most traded options can be exercised by the buyer at any time before they expire and are known as ‘American- style’ options. Those which can only be exercised by the buyer at maturity are known as ‘European-style’ options. Fundamentally, options offer the trader an opportunity to participate in short-term price movements with limited capital outlay: as a geared investment, an option puts less money at risk. It also offers a fixed level of maximum potential loss. They can be used to provide a hedge against a fall in the price of an asset and to make short-term adjustments to a portfolio’s exposure. Options offer clear advantages for traders. They are suitable for any market conditions and pose minimum risk - but to win, you really need a strategy. Some strategies, such as writing covered calls, are fairly simple to understand and execute. There are more advanced strategies, such as spreads and collars, that require two opening transactions. These strategies are often used to limit the risk that comes with options but they may also limit potential gains. While options offer many possible paths to profit, they are more difficult to understand than competing products such as spread bets and far more complex than straightforward shares trading. Before seriously entering the world of options, you would be well advised to study their workings in detail. Fortunately, Liffe has a comprehensive learning platform covering both options and futures which is easy to access and, moreover, free: go to liffe.npsl.co.uk/   This ‘How to’ guide is produced by Shares Magazine and is only for general information and use, and is not intended to address particular requirements. The value of investments and the income derived from them can go down as well as up. Past performance is not necessarily a guide to future performance. You should get professional financial advice before making any investment decisions.