What Markets to Trade – Stocks, Options or Futures?
If you've made any attempt to inquire about options or futures as investment alternatives,
there's a good chance you've been advised to steer clear of them as high-risk investments, and that you've left it
at that without acquiring even a basic understanding of what they are or how they work. In fact, to be an
intelligent investor it's absolutely critical to have a broad understanding of all avenues of investment available
to you. This article will quickly demystify options and futures empowering you to make more well-informed
An options contract is one that, in exchange for its premium (cost), gives the buyer the right, but not the
obligation, to buy or sell an asset at a specified price from (or to) the option seller within a specified time
period, or on a specified date. Options are referred to as either ‘puts' or calls'; these two terms simply refer to
whether you are buying or selling. A put gives the stock or commodity holder the right to sell, a call gives the
right to buy. The purchaser of a put or call may choose not to exercise the specified option, but in that case the
option premium becomes a loss.
The main difference between a stock and an option is that a stock is a part ownership of a company whereas a
stock option is only a contract giving you the right to buy or sell some stock
at some price on some date, all of which are specified at the time of purchase of the option. One of the attractive
things about stock options is that the buyer cannot lose more than the premium paid no matter what happens to the
underlying stock, whereas potential for profit is theoretically unlimited.
You should be aware that there are two basic types of options with one very important difference in the way they
are exercised. American options can be exercised at any time between the purchase date and the expiration date
whereas European options are exercised only on the expiration date. Stock options are always American style; many
index options are European style.
A normal stock option's expiration date may be up to nine months from the date the option is first listed.
Longer-term options are called LEAPs and may expire up to three years after the listing date.
Click here to learn more about options trading.
A futures contract is an agreement to buy or sell an asset in a designated future month at a price agreed upon
by the buyer and seller. The difference between a futures contract and an options contract is that the latter gives
the right to buy or sell whereas a futures contract is the promise to actually make a transaction. Note that the
date of the transaction on a futures contract is specified by month only since all futures transactions occur on
the Saturday immediately following the third Friday of each month.
Futures and options are both part of a
class of securities called derivatives, so named because they derive their value from the worth of an underlying
investment. The reason many people shy away from trading derivatives such as futures and options is that the game
is clearly zero-sum; that is, one individual makes a profit from the option transaction at the expense of the
individual at the other end of the transaction.
It should be emphasized that while options and futures are viable supplements to stock investment, they should
not be used as a replacement to stock investing but merely as investment alternatives. It's advisable to center
your investment strategy on stocks as your main choice for consistent long-term growth and use futures and options
in moderation and primarily on a short-term basis.
Next: Taking Advantage of Market Behavior