 Personal Finance PowerPoint Presentation, Options and Futures. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia, Options vs. Futures. What's the difference, which you can find online. Take a look at the references. Resources continue your research from there. This by Adam Hayes, updated January 29, 2022. In prior presentations, we've been looking at investment goals, investment strategies, investment tools, keeping in mind the two primary categories of investments, that being fixed income, typically bonds, and then equities, typically stocks. And now we're getting into a little bit more complex territories as we look at the options versus the futures. What's the difference? So an options contract gives an investor the right, but not the obligation to buy or sell shares at a specific price at any time as long as the contract is in effect. So now we have the capacity, the option to take action, but not the requirement to do so. So note that there is value in the options, but it's a little bit more complex to think about because it's the value of the capacity to take action and you don't have to actually make the trade. And so that there's where the complexity lies. So once again, an option contract gives an investor the right, but not the obligation to buy or sell shares at a specific price at any time as long as the contract is in effect. By contrast, a futures contract requires a buyer to purchase shares and a seller to sell them on a specific future date unless the holder's position is closed before that expiration date. So the futures contract, once again, we have this concept of a trade taking place, but not in the current timeframe. We're thinking about it, a commitment for it to basically happen in the future. So there's value in that, but it gets a little bit complex to value it given the fact that it's a contract for something to happen in the future. So once again, by contrast, a futures contract requires a buyer to purchase shares and a seller to sell them on a specific future date unless the holder's position is closed before the expiration date. So options and futures are both financial products investors can use to make money to hedge current investments. So you might use these kind of techniques as a strategy, especially in particular kind of industries and situations to basically hedge or reduce risk. Or you can basically use them as another way to basically speculate and try to make money on the market. So both an option and future allow an investor to buy an investment at a specified price by a specific date, but the markets for these two products are very different and how they work and how risky they are to the investor. So let's first take a look at the options. Options are based on the value of an underlying security such as a stock. As noted above, an options contract gives an investor the opportunity, but not the obligation to buy or sell the asset at a specific price while the contract is still in effect. Investors don't have to buy or sell the asset if they decide not to do so. So the value of the option is the option to buy or sell. So options are a derivative from the investment. So you may hear this term whenever you hear this term in investing, it can be a little bit intimidating, especially if you're talking about basically like economic terms and there's a financial crisis and you're trying to say, well, what will the derivative investments impact on them and so on. So you can see it gets a little bit complex to kind of value derivatives because but you can see what the derivative is. You can see that it basically has value, but because it's an option, it's a little bit complex to kind of determine what that value is. Right. So they may be offers to buy or sell shares, but don't represent actual ownership of the underlying investment. So the option doesn't represent that you own the investment, but you have the capacity to buy it right until the agreement is finalized. So buyers typically pay a premium for options contracts, which reflect 100 shares of the underlying asset premiums generally represent the assets strike price, the rate to buy or sell it until the contract's expiration date. This date indicates the day by which the contract must be used. Types of options. We've got the call and put options. There are only two kinds of options. We've got the call options and the put options. A call option is a offer to buy a stock at the strike price before the agreement expires. A put option is an offer to sell the stock at a specific price. So let's look at an example of each first of a call option. So an investor opens a call option to buy stock XYZ at $50 strike price sometime within the next three months. So now they have the option to do it. They've got the capacity to buy the stock for the $50 within the next three months of the stock XYZ at the $50. So the stock is currently trading at $49. If the stock jumps to $60, the call buyer can exercise the right to buy the stock at $50. So now you've got the option because you said, hey, I'm going to set the option or buy the option to be able to buy it. And now the stock, if it jumps up to $60, well, now you can still buy it at the $50 at that point. So that buyer can then immediately sell the stock for $60 for a $10 profit. So obviously you can then buy the stock and you could turn around and sell it or you can hold on to it at that point in time. So other possibilities. Alternatively, the option buyer can simply sell the call and pocket the profit since the call option is worth $10 per share. So at this point in time, you might also say, okay, now the option is clearly has a value to it at this point in time because it's $10 over. If you were to sell the option, the person who buys the option could do just what we just talked about. They could basically buy the stock and then sell it again, making that $10. So instead of actually buying the stock and selling the stock, you might be able to sell the actual option itself. So now there's a market for the option. So if the option is trading below $50 at the time the contract expires, the option is worthless. So once again, if the option is trading below $50 at the time the contract expires, meaning you bought the option at $50, the stock then goes down in price. No one's going to want the option because the option is not going to be useful at that point in time because the stock went down in price. So the call buyer loses upfront payment for the option called the premium. So meanwhile, if an investor owns a put option to sell XYZ at $100. So now we have the sell side of things, the option to sell it at a specific price and XYZ's price falls to $80 before the option expires. The investor will gain $20 per share minus the cost of the premium. If the price of XYZ is above $100 at expiration, the option is worthless and the investor loses the premium paid upfront. So you got the same kind of thing in essence happening in reverse here. So either the put buyer or the writer can close out their option position to lock in a profit or loss at any time before expiration. This is done by buying the option in the case of the writer or selling the option in the case of the buyer. The put buyer may also choose to exercise the right to sell at the strike price. Now we have the futures. The futures contract is the obligation to sell or buy an asset at a later date at an agreed upon price. So different than the option. Once again, a futures contract is the obligation to sell or buy an asset at a later date at an agreed upon price. Futures contracts are true hedge investments and are most understandable when considered in terms of commodities like corn or oil. These kind of futures, you often think of them in specific scenarios used in a specific way in order to basically mitigate or lower the hedge or lower risk in those scenarios. So for instance, a farmer may want to lock in an acceptable price upfront in case market prices fall before the crop can be delivered. So if you're in like a farming kind of situation, obviously you're in a situation where you're putting a huge amount of capital investment into something that you're hoping will yield growth in terms of whatever your crop will be, and then you're kind of subject to the market at that point in time because now you have all the food and you've got to basically sell the food. It only lasts for a certain point in time. So at the point in time, you make the crop where you start investing in the crop that you're going to be investing in and that's a long distance away from the time when you're actually at market. So you might want to hedge your bets in case like the market falls or something like that and you might use futures contracts to help with that. So the buyer also wants to lock in a price upfront too if prices soar by the time the crop is delivered. So examples, let's demonstrate with an example. Assume two traders agreed to a $50 per bursal price on a corn futures contract. If the price of corn moves up to $55, the buyer of the contract makes a $5 per barrel. The seller on the other hand loses out on a better deal. The market for futures has expanded greatly beyond oil and corn. Stock futures can be purchased on individual stock or on an index like the S&P 500. The buyer of futures contract is not required to pay the full amount of the contract upfront. The percentage of the price called an initial margin is paid. For example, an oil futures contract is for 1000 barrels of oil. An agreement to buy an oil futures contract at $100 represents the equivalent of $100,000 agreement. The buyer may be required to pay several thousand dollars for the contract and may owe more if the bet on the direction of the market proves to be wrong. So you can use these kind of contracts in terms of a practical way to hedge or mitigate risk. And you can also use these kind of speculative things in a speculative way, purely speculative trying to make gains on speculation of what direction the market is going to be taking. So who trades futures? Futures are invented for institutional buyers. These dealers intend to actually take possession of crude oil barrels to sell to refiners or tons of corn to supermarket distributors. Establishing a price in advance makes the business on both sides of the contract less vulnerable to big price swings. So again, you've got a lot of commitment going on and a big timeframe that is in place. If you can settle on a price upfront, then both of you are less subject to the validity of the market. And it could obviously, the validity of the market could work out to the pros and cons of either side. But it's just like when you invest in stock, you've got to mitigate that risk with the potential loss or gains and losses that will be related to them. So retail payers, however, buy and sell futures contracts as a bet on the price direction of the underlying security. They want to profit from the changes in the price of futures up or down. They do not intend to actually take possession of any products. So key differences, aside from the differences noted above, there are other things that set both options and futures apart. Here are some other major differences between the two financial instruments. Despite the opportunities to profit with options, investors should be wary of the risks associated with them. So options, because they tend to be fairly complex, options contracts tend to be risky. So when you add, you know, you kind of a step away from the actual valuation of the underlying assets, because obviously if you buy the underlying assets a little bit more straightforward, when you're looking at things that are derivative, they have value, but they're kind of a step away from the actual thing that's giving it value. It adds, of course, a level of risk or level of complexity. So both call and put options generally come with the same degree of risk. When an investor buys a stock option, the only financial liability is the cost of the premium at the time the contract is purchased. So at least you kind of know what the cost is when you're dealing with the options, because it's, you know, you're purchasing the option, that's what the cost is going to be. So however, when a seller opens a put option, the seller is exposed to the maximum liability of the stock's underlying price. If a put option gives the buyer the right to sell the stock at $50 per share, but the stock falls to $10, the person who initiated the contract must agree to purchase the stock for the value of the contract or $50 per share. So the risk to the buyer of a call option is limited to the premium paid upfront. So once again, we have a little bit difference here, depending on which side of the option you're on here, right? So the risk to the buyer of a call option is limited to the premium paid upfront. This premium rises and falls throughout the life of the contract. It is based on a number of factors, including how far the strike price is from the current underlying securities price as well as how much time remains on the contract. This premium is paid to the investor who opened the put option, also called the option writer. So the option writer, the option writer is on the other side of the trade. This investor has unlimited risk. Assume in the example above that the stock goes up to $100. The option writer would be forced to buy the shares at $100 per share in order to sell them to the call buyer for $50 a share. In return for a small premium, the option writer is losing $50 per share. Either the option buyer or the option writer can close their positions at any time by buying a call option, which brings them back to flat. The profit or loss is the difference between the premium received and the cost to buy back the option or get out of the trade. On the futures, options may be risky, but futures are riskier for individual investors. So again, oftentimes the futures you might be thinking of them. So options, as we can see, have levels of risk depending on where you are at or how you are using the options. But you might see some appropriate kind of ways that you might use that tool. On the futures type of things, you would think that mostly they would be used for those specific circumstances for people that are trying to mitigate risk. If you're using them purely for speculation, then you would think there's going to be a significant amount of risk related to that. So futures, so options may be risky, but futures are riskier for the individual investor. Futures contracts involve maximum liability to both the buyer and the seller. So as the underlying stock price moves, either party to the agreement may have to deposit more money into their trading account to fulfill a daily obligation. This is because gains on the futures positions are automatically marked to market daily, meaning the change in the value of the position up or down is transferred to the futures accounts of the parties at the end of every trading day. Options, to complicate matters, options are bought and sold on futures. So now we've got kind of a mix between the two. Once again, to complicate matters, you could have options are bought and sold on futures. But that allows for an illustration of the differences between options and futures. So in this example, one options contract for gold on the Chicago Mercantile Exchange, the CME, has its underlying asset one COMEX Gold Futures contract. So an options investor may purchase a call option for a premium of $2.60 per contract with a strike price of $1,600 expiring in February 2019. The holder of this call has a bullish view on gold and has the right to assume the underlying gold futures position until the option expires after the market closed on February 22, 2019. If the price of gold rises above the strike price of $1,600, the investor will exercise the right to buy the futures contract. Otherwise, the investor will allow the options contract to expire. The maximum loss is the $2.60 premium paid for the contract. Futures contract. The investor may instead decide to buy a futures contract on gold. One futures contract has its underlying asset at 100 troy ounces of gold. This means that the buyer is obligated to accept 100 troy ounces of gold from the seller on the delivery date specified in the futures contract. Assuming the trader has no interest in actually owning the gold, the contract will be sold before the delivery date or rolled over to a new futures contract. As the price of gold rises or falls, the amount of the gain or loss is credited or debited to the investor's account at the end of each trading day. If the price of gold in the market falls below the contract price the buyer agreed to, the futures buyer is still obligated to pay the seller the higher contract price on the delivery date.