Futures and options pdf basics of investing

They combine having a market opinion speculation with limiting losses hedging. Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg.

There are many types of spreads and variations on each. Here, we just discuss some of the basics. Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration but a different strike. A bull call spread, or bull call vertical spread , is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike.

The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one. Similarly, a bear put spread , or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a calendar spread or time spread. A butterfly spread consists of options at three strikes, equally spaced apart, wherein all options are of the same type either all calls or all puts and have the same expiration.

In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of buy one, sell two, buy one. If this ratio does not hold, it is no longer a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor —the difference is that the middle options are not at the same strike price.

Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options. For instance, if you buy an equal amount of calls as you sell puts at the same strike and expiration, you have created a synthetic long position in the underlying.

Boxes are another example of using options in this way to create a synthetic loan, an options spread that effectively behave like a zero-coupon bond until it expires. American vs. European Options American options can be exercised at any time between the date of purchase and the expiration date.

European options are different from American options in that they can only be exercised at the end of their lives on their expiration date. The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option.

This is because the early exercise feature is desirable and commands a premium. There are also exotic options , which are exotic because there might be a variation on the payoff profiles from the plain vanilla options. Or they can become totally different products all together with "optionality" embedded in them. For example, binary options have a simple payoff structure that is determined if the payoff event happens regardless of the degree.

Other types of exotic options include knock-out, knock-in, barrier options, lookback options, Asian options , and Bermuda options. Again, exotic options are typically for professional derivatives traders. Short-Term Options vs. Long-Term Options Options can also be categorized by their duration.

Short-term options are those that generally expire within a year. Long-term options with expirations greater than a year are classified as long-term equity anticipation securities , or LEAPs. LEAPs are identical to regular options except that they have longer durations. Time value does not decay as rapidly for long-term options because they have a longer duration. Time value decay is minimal for a relatively long period because the expiration date is a long time away.

The main risk component in holding short-term options is the short duration. The main component of holding long-term options is the use of leverage, which can magnify losses, to conduct the trade. They are fairly cheap to purchase. They are more expensive compared to short-term options. They are generally underpriced because it is difficult to estimate the performance of a stock far out in the future.

They are generally used as a proxy for holding shares in a company and with an eye toward an expiration date. LEAPs expire in January and investors purchase them to hedge long-term positions in a given security. They can be American- or European-style options.

They are American-style options only. They are taxed at a short-term capital gains rate. They are taxed at a long-term capital gains rate. Options can also be distinguished by when their expiration date falls. Sets of options now expire weekly on each Friday, at the end of the month, or even on a daily basis. Index and ETF options also sometimes offer quarterly expiries.

Reading Options Tables More and more traders are finding option data through online sources. Though each source has its own format for presenting the data, the key components of an options table or options chain generally include the following variables: Volume VLM simply tells you how many contracts of a particular option were traded during the latest session.

They could be offers to purchase or sell stock, but they do not really represent the actual ownership of the underlying investments, at least, not until the agreement is final. Typically, buyers pay a premium for contracts in options, and these reflect a hundred shares of whatever the underlying asset is. This is the date that indicates when the contract has to be used. Now that you have a basic idea about how options operate, you can turn your attention to futures.

In futures and options trading, a futures contract is representative of an obligation to purchase or sell any asset at a future later date at a pre-agreed upon price. Futures act as a veritable hedge as far as your investments go, and are understood well when you consider commodities such as oil or wheat.

For example, a farmer may wish to lock on an acceptable value price initially, just in case prices in the markets dip before any crop can be delivered. The buyer might also wish to fix an upfront price in case there is a hint of prices soaring by the time of crop delivery.

Futures are leveraged products and they work both ways. Here is how it works! You buy stocks worth Rs. So, what the enthusiastic salesman told you was correct. The only thing he did not tell you was that it works similarly for losses also and they also tend to get magnified when you trade in futures. It is fine as long as you are aware that the impact of leverage through margins works both ways; in case of profits and in case of losses. Buying options means limited risk, but you rarely make money.

The truth is that option sellers take a higher risk and therefore they make money more often compared to option buyers. The truth is that your prospects of making profits are also limited when you buy options. In futures and options trading, you may just find that futures may be better than options for you. It all depends on how you trade and how much you can afford to lose.

Options are asymmetrical and that is the difference. Let us understand this with an example. If the price goes to then A makes a profit of Rs. The reverse will hold true if the stock price goes down to Rs. Margins on futures can go up sharply in volatile times.

Many of us believe that futures have an advantage over cash market buying as you can leverage by buying on margin. But these margins can go up sharply in times of volatility.

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Options and futures are two varieties of financial derivatives investors can use to speculate on market price changes or to hedge risk. Both options and futures allow an investor to buy an investment at a specific price by a specific date. But there are important differences in the rules for options and futures contracts, and in the risks they pose to investors.

Key Takeaways Options and futures are two types of derivatives contracts that derive their value from market movements for the underlying index, security or commodity. An option gives the buyer the right, but not the obligation, to buy or sell an asset at a specific price at any time during the life of the contract.

A futures contract obligates the buyer to purchase a specific asset, and the seller to sell and deliver that asset, at a specific future date. Futures and options positions may be traded and closed ahead of expiration, but the parties to the futures contracts for commodities are typically obligated to make and accept deliveries on the settlement date. Options Options are based on the value of an underlying stock, index future, or commodity. An options contract gives an investor the right to buy or sell the underlying instrument at a specific price while the contract is in effect.

Investors may choose not to exercise their options. Options are financial derivatives. Option holders do not own the underlying shares or enjoy shareholder rights unless they exercise an option to buy stock. Options contracts for stocks typically provide the right to buy or sell shares of the stock at the specified strike price before the contract expiration date, and the price of the option is known as its premium.

In the U. Options exchanges are also closed on holidays when stock exchanges are closed. A call option confers the right to buy a stock at the strike price before the agreement expires. A put option gives the holder the right to sell a stock at a specific price. Let's look at an example of each—first of a call option. The call buyer loses the upfront payment for the option, called the premium. Either the put buyer or the writer can close out their option position to lock in a profit or loss at any time before its 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. Futures A futures contract is the obligation to sell or buy an asset at a later date at an agreed-upon price.

Futures contracts are a true hedge investment and are most understandable when considered in terms of commodities like corn or oil. For instance, a farmer may want to lock in an acceptable crop price in case market prices fall before the crop can be delivered. The buyer also wants to lock in a price to protect against a subsequent rise in prices. Examples Let's demonstrate with an example. The seller, on the other hand, loses out on a better deal. The market for futures has expanded greatly beyond oil and corn.

Single-stock futures have not been available in the U. Buyers of a futures contract are not required to pay the full value of the contract up front. Instead, they cover a percentage of the price as an initial margin. For example, an oil futures contract is for 1, barrels of oil. The buyer may be required to pay several thousand dollars up front, and may be required to increase that commitment later if oil prices subsequently drop.

Futures markets primarily serve institutional investors. These may include refiners seeking to hedge crude costs or cattle producers seeking to lock in feed prices. Who Trades Futures? Futures markets serve commodity producers, commodity consumers, and speculators. Futures contracts can protect buyers as well as sellers from wide price swings in the underlying commodity. They also cater to institutional as well as retail traders seeking to profit from expected changes in market prices for the underlying security or commodity.

Agricultural commodities include rice, soybeans, wheat, corn, coffee, cocoa, and animal products. The prices of various commodities are changing continuously in markets thanks to global variations in supply and demand. In this case, hedgers enter into futures contracts to supply specified quality and quantity of commodities at a predetermined price. This helps them avoid potential losses from future price fluctuations. On the other hand, speculative traders enter into futures contracts to benefit from the potential price fluctuation that hedgers try to avoid.

For speculators, the primary advantage of futures contracts is the use of leverage. With futures contracts, they can afford to purchase a higher quantity of commodities that they would otherwise not afford to buy in the spot market. A futures contract can be used to buy or sell a particular commodity asset at a predetermined price at a specified time in the future. If traders expect the price of a commodity will rise, they buy their futures and take long positions.

Conversely, if they expect the value of a commodity to go down, they resort to short selling. Futures Trading Reddit Thanks to the global lockdowns of , social trading is on the rise. Over the past year, social media forums like Reddit have had a substantial impact on the capital markets, with Reddit emerging as the biggest disruptor. The platform offers an excellent social discussion platform where users can share trading strategies, ask burning questions, dispel myths, and share relevant news.

The sheer quantity of information available is massive, and with careful filtration, it can prove to be an invaluable source of information. Such niche communities will aid beginners in trading as you have a community of experts to chat with and ask questions, basically getting investment advice for free.

Seasoned traders can also use these forums to share their knowledge and give back to the community. Futures trading is all about betting on future price movements, and no one can definitively say in which way they will move.

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Futures A futures contract is the obligation to sell or buy an asset at a later date at an agreed-upon price. Futures contracts are a true hedge investment and are most understandable when considered in terms of commodities like corn or oil. For instance, a farmer may want to lock in an acceptable crop price in case market prices fall before the crop can be delivered. The buyer also wants to lock in a price to protect against a subsequent rise in prices.

Examples Let's demonstrate with an example. The seller, on the other hand, loses out on a better deal. The market for futures has expanded greatly beyond oil and corn. Single-stock futures have not been available in the U. Buyers of a futures contract are not required to pay the full value of the contract up front. Instead, they cover a percentage of the price as an initial margin.

For example, an oil futures contract is for 1, barrels of oil. The buyer may be required to pay several thousand dollars up front, and may be required to increase that commitment later if oil prices subsequently drop. Futures markets primarily serve institutional investors. These may include refiners seeking to hedge crude costs or cattle producers seeking to lock in feed prices.

Who Trades Futures? Futures markets serve commodity producers, commodity consumers, and speculators. Futures contracts can protect buyers as well as sellers from wide price swings in the underlying commodity. They also cater to institutional as well as retail traders seeking to profit from expected changes in market prices for the underlying security or commodity. Financial speculators typically don't intend to acquire the underlying commodity when the contract is settled, and are likely to sell their position beforehand.

Futures trading hours may differ from stock and options markets. Normal trading hours are often a. Some futures products trade hours a day on Globex. Key Differences Aside from the differences noted above, there are other things that set options and futures apart.

Here are some other major differences between these two financial instruments. Options Because they tend to be fairly complex, options contracts tend to be risky. Call and put options can be equally risky. When an investor buys a stock option, its risk is defined by its cost, or premium. In the worst case scenario, the option premium spent will be a total loss if the options expire worthless.

However, selling a put option exposes the seller to a loss potentially much larger than the premium gained from a possible decline in the value of the shares underlying the stock option. The risk to the buyer of an option is limited to the premium paid up front.

An option's price fluctuates based on a number of factors, including how far the strike price is from the underlying security's current price, as well as time remaining before expiration. This premium is paid to the seller of the put option, also called the option writer.

The Option Writer The option writer is on the other side of the trade. Option sellers take on more risk relative to option buyers. Since there is no upper bound to a share price, there is no upper limit to how much the seller of a call option can lose on the rise in the share price. Option sellers may own the underlying stock to limit their risk. The option buyer as well as the option seller may trade out of the position in the options market.

Futures Options may be risky, but futures can be riskier still for the individual investor. Futures contracts obligate both the buyer and the seller. Futures positions are marked to market daily, and, as the underlying instrument's price moves, the buyer or seller may have to provide additional margin.

So essentially, if the price of oil increases during this period, you will make a profit. Investors also have the option to roll over contracts, meaning they can close the existing contract and open a new one with an extended expiry date at the then-current market price. This is a good way to avoid immediate losses; in fact, this is what happened to Oil futures during the onset of the pandemic.

As Oil prices plummeted, investors holding Oil futures had to roll over their contracts and enter into long positions to ride out the slumping markets until oil prices recovered. Trading Commodity Futures Commodities are primary raw materials used as input in other production stages; they can include agricultural products, mineral ores, and fossil fuels.

They generally fall into one of three categories — metals, energy, and agriculture. Metal commodities consist of metals like gold, silver, platinum, and copper, while energy commodities include crude oil, heating oil, natural gas, and gasoline. Agricultural commodities include rice, soybeans, wheat, corn, coffee, cocoa, and animal products. The prices of various commodities are changing continuously in markets thanks to global variations in supply and demand. In this case, hedgers enter into futures contracts to supply specified quality and quantity of commodities at a predetermined price.

This helps them avoid potential losses from future price fluctuations. On the other hand, speculative traders enter into futures contracts to benefit from the potential price fluctuation that hedgers try to avoid.

For speculators, the primary advantage of futures contracts is the use of leverage. With futures contracts, they can afford to purchase a higher quantity of commodities that they would otherwise not afford to buy in the spot market. A futures contract can be used to buy or sell a particular commodity asset at a predetermined price at a specified time in the future. If traders expect the price of a commodity will rise, they buy their futures and take long positions.

Conversely, if they expect the value of a commodity to go down, they resort to short selling.