Investing in the futures and options markets means investors must be prepared to take on more risk and become active traders compared with purchasing stocks, mutual funds or ETFs.
Both of the markets are more complex than the stock market and often experience more volatility.
A futures contract is a forward contract to buy an asset such as a stock or commodity in the future at a fixed price.
An options contract allows an investor to sell or buy an asset such as stock, ETF or stock index at a predetermined price over a certain period of time.
How to Invest Using Futures Contracts
Investors can purchase and sell futures contracts through the Chicago Board of Trade and the Mercantile Exchange.
There are various types of futures contracts and they include: energy, grains, metals, forest, livestock, softs, interest rates, currency and the stock index.
Many retail investors avoid trading in futures because it is a more complex market. But the contracts in the futures market allow individuals to hedge against the current holdings in their portfolio.
A small amount of capital allows an investor to gain a high amount of leverage for a stock or commodity.
Some individuals invest in popular broad stock market indexes such as the S&P 500 index because it is a low-risk, low-cost investment. While investing $10,000 into an E-Mini S&P 500 (NQ) futures contract will also have exposure to the same index as investing $10,000 into an S&P 500 mutual fund or ETF, the risk is five to ten times higher for the same dollar amount of investment.
Although an investor can generate a large return if the market moves in their favor, there is also the possibility that he or she can lose their entire investment if the market moves in the other direction.
Advantages of Futures
The futures market gives investors exposure to commodities such as coffee, cocoa, natural gas or crude oil while also diversifying their portfolios.
Another advantage of the futures market is that it is open nearly 24 hours. This also means that there is greater risk in case there is a massive tsunami, earthquake, fire or an economic or political situation develops.
For investors who want to show their market opinion either agreeing with or against the general market sentiment, there are products such as the E-mini Nasdaq futures (QCN).
The futures market demonstrates capital efficiencies - one futures contract allows people to spend less money to take a similar position on a market sentiment.
Hedging in futures allows sophisticated investors or institutional players to lower their risk compared to other assets in their stock or bond portfolio.
Although investing in the futures market gives retail investors additional exposure to commodities and energy that stocks and ETFs cannot generate, being cautious is the best strategy. Many experts such as financial advisers recommend that only 5% to 15% of an individual's portfolio consist of futures.
How to Purchase Futures
Brokerage firms have various rules about opening a futures account, but the majority will require approval to open one that is largely based on an investor's past experience with trading.
Each product, such as interest rates, energy, stock indexes, currency and agricultural have their own trading hours and rules about margin requirements.
Novice traders can conduct "paper trading" on the simulated platforms of the brokerage firms until they understand how the markets react to news, economic statistics and earning of companies.
Learning how to trade coffee, orange juice or crude oil is challenging and all of them require different strategies that an investor can only learn over time.
Traders can learn discipline, patience and not to react to emotionally when a futures contract does not yield the result they had predicted. Investors also have to learn to set limits ahead of their trade and sell when the contract is losing money instead of holding onto it.
Risks of Futures
Trading futures can be riskier because of the 24-hour market, so investors cannot be complacent. For instance, individuals who want to invest in crude oil, known as CL, should be aware that the market is open from 5 p.m. to 4 p.m. CT Sunday through Friday with a 60-minute break each day at 4:00 p.m. CT.
If a geopolitical event arises, an investor must be prepared to act or risk losing a large amount of capital. The amount of volatility in trading futures can also be much higher than trading stocks. The margin call or the amount of money needed by an investor to deposit into their brokerage account to meet the minimum requirement can be a hefty amount.
Investors who want immediate gratification, are not liquid and are hasty with their trades should strongly consider whether trading futures will help them generate higher returns.
How to Invest Using Options
Buying and selling options is done on the options market, which trades contracts based on securities. Buying an option allows you to buy shares at a later time is called a "call," while purchasing an option that allows you to sell shares at a later time is called a "put."
Both allow an investor to either sell or buy the underlying security at a specific date and price in the future. If an investor chooses not to buy the stock or commodity, he/she is not obligated to do so.
A call option tends to be bullish, while put options are typically bearish.
The difference in trading options compared to stocks is that the individual does not own shares in a company.
The price investors chose to buy the underlying security is called the "strike price" while the fee to buy the option contract is called the "premium." The strike price means the investor is betting that a stock will rise or decline against the current price.
Advantages of Options
Some investors prefer to trade options compared to futures because the risk is lower. Investors can withdraw from an options contract before it matures. The price of the option, known as its premium is only a percentage of the underlying asset or security.
One advantage of buying an option is that an investor can purchase or sell an option in the future at a set price for a rather small amount of capital.
Options can also generate more income for an investor, be more resilient to downturns in prices and help an individual obtain a better price on different stocks.
How to Purchase Options
Brokerage firms have various rules about opening an options account, but the majority will require approval to open one that is largely based on an investor's past experience with trading similar to trading futures.
Options are also traded on exchanges such as the Cboe and have myriad products such as the VIX index, stock indexes, mini, weekly, end-of-month, quarterlies, strategy benchmark indexes and social media indexes.
Novice options traders can conduct "paper trading" on the simulated platforms of the brokerage firms until they understand how the markets react to news, economic statistics and earning of companies.
Risks of Options
There are various types of options to purchase. The most common ones are calls, puts, long-dated contracts and short-dated contracts.
There are some options contracts that are complex, such as the butterfly, iron condor, straddle and strangle. The amount of capital that an investor can lose is much greater compared to purchasing a stock or stock index or ETF.
The options market is open nearly 24 hours a day, which means news from another country can affect stock prices and a trader also has the potential to put more capital at risk.
One popular mistake that some individuals make is believing that it is necessary to hold onto a call or put option until the expiration date. Options give traders the opportunity to exercise the contract immediately. For example, if the underlying stock rises quickly and the investor can either double or triple their call or put option's value, there is no need to wait until the end of a monthly contract, such as 25 days.
Another mistake that some investors make is believing that a cheaper option is the better choice. Instead, it can mean that the options contract is riskier and the profit could be less if the trade goes sideways.
How to Choose Between Futures and Options
Adding either futures contracts or options to your portfolio can be challenging and risky. Depending on your risk, amount of liquidity and when you want to retire, determining one that is suited for you is tricky. Some investors choose the index-based futures contracts such as the E-Mini S&P 500 or E-mini Nasdaq futures because they are less complex while others chose a specific commodity such as crude oil (CL - Get Report) because they are familiar with the industry and its risks.
Others chose to purchase options on stocks that are popular or have large volumes such as tech stocks or ones included in the Dow Jones Industrial Average, Nasdaq or S&P 500.
Being more conservative in your trading strategy for both futures contracts and options is a good rule of thumb to follow to avoid losing large amounts of capital.
Other retail investors who do not want to cope with the higher degree of risk opt to defer their decisions to a financial adviser who has demonstrated expertise in trading these more complex assets.