In our last Investing Basics article, we talked about mutual funds. Today, we’ll discuss options and futures. Later in this series, we’ll look at short-term savings vehicles.
What Are Derivative Securities?
Options and futures belong to a class of securities known as derivatives. These are securities whose value is derived from another underlying asset. In the case of options, the underlying asset is often a stock (thought it can be an index, exchange-traded fund, currency, or bonds). For futures, the underlying asset is usually a commodity (like grains, oilseeds, metals, petroleum, livestock, food items, or fiber) but can also include stock indexes, currencies, or bonds. In reality, options and futures can be based on nearly anything if there’s a market for them.
What Is an Option?
Options are securities that give you the opportunity (or “option”…) to buy or sell the underlying security at a specific price over a set period of time. If the option lets you buy, it’s a “call option”. If it lets you sell, it’s a “put option”. Options that cover a long period of time are often called LEAPS (Long-term Equity AnticiPation Securities).
Long-term options that let you buy a certain number of shares from a company are called “warrants”. These can be for 5, 10, or even 20 years. Although they are similar to regular options, they can only be issued by the company that issues the underlying stock. Regular options can be issued by anyone. Warrants are usually added to bonds when the issuing company needs to “sweeten the deal”.
What Is a Futures Contract?
A futures contract is an obligation to deliver or accept a certain amount of the underlying asset at a specific price on a specific date. (Many people just call them “futures” but that’s just a shorter way of saying “futures contracts”.) Where an option gives you the choice to buy or sell, a futures contract is a commitment to buy or sell. So if you buy a pork bellies futures contract and hold it until the delivery date, you better have a place to store 40,000 pounds of future bacon!
When used for hedging purposes, futures contracts are most often bought and sold by processors and manufactures or producers and farmers. Futures contracts allow these people and businesses to lock in their costs or income. Many of the farmers in my church use contracts to lock in the prices for their milk, corn, and soybeans. This helps them plan their income easier and protect against declining prices, but it also obligates them to deliver a specific amount regardless of how their cows or crops perform.
You Don’t Need to Know Much about Options and Futures
Honestly, the average investor doesn’t need to know much about options and futures. There are some limited applications where they can be used to hedge (protect) an investment. But for the most part, people use them to speculate (in other words, gamble!). And speculation is not investing. However, it is useful to have a basic knowledge of options and futures so you can recognize the risks and the potential benefits. If you want to keep learning about investing, make sure you sign up for free updates to Provident Planning!