Can someone explain in lay language what are future and options and why are they more desirable than stocks?

Question

I just wish to find out in very simple language

to get ready to start investing if I should trade

futures, options or stocks?

What are the differences and similarities?

What is the reason for invention of options

and futures as opposed to regular stock?

Also, is it a good idea to invest now

because stock market is going down,

or should I wait before it starts consistently

going up again?

What is a good amount to start with?

Please keep your answers very simple,

if possible avoid using yield, dividend

and "complicated" language without

explaining what it means first.

Thanks :-)

Answer 1

If you are just beginning, you ought to stay away from options and futures.  Not that there is anything inherently bad...they are just not for beginners.  And you'd better know what all that 'complicated' language means before you invest a cent.  'Yield' and 'dividend' are very basic terms.  You need to educate yourself a lot more.  

End of sermon...beginning of answer.  

Lets say someone wanted to buy a share of IBM.  They could go out and buy the stock.  Hopefully, understanding that is easy.  

However, lets say they didn't want to buy it until September.  

They could buy a futures contract where the seller agrees to sell you a share of IBM at a specified price in September.  That is what is refered to as a future because you are agreeing to buy or sell something in the future.  Futures contracts were initially for items such as corn.  A farmer might want to sell a crop that wouldn't come in until October, and a bakery might want to buy the corn it would need in October in advance.  A futures contract would be a deal between a farmer and a bakery for sale of corn to be delivered in October.  Futures exchanges used standardized contracts.  One of the advantages of a standardized contract was that either the farmer or the bakery could change its mind.  The farmer could buy the contract back from anyone willing to sell it to him as opposed to just from the bakery, and the bakery could sell the contract to anyone willing to buy it from them.  

Options is where the seller grants the buyer the right but not the obligation to purchase something at a specific price at a specific time.  They are called options because the buyer has the choice (or option) whether to buy the stock at the agreed upon price or not.  The seller is paid a fee (called a premium) for granting the buyer that choice.  

For instance, you might buy an option to buy IBM at $130 per share before September 15 at $10 per share (all hypothetical numbers, I didn't look up the actual numbers).  That would give you the right to buy a share of IBM at $130 per share.  If you held the option until September 15, and IBM went to $120 on September 15, the option would expire worthless, and you would not exercise it (exercise means buying the share from the person who sold you the option for $130...once exercised, the option has no further value).   Obviously, it would be cheaper to buy the share on the open market.  You'd lose the $10 you paid for the option.  If IBM went to $150, you could exercise the option to buy IBM at $130.  If you were to immediately resell it at $150, you would make a $10 profit ($150 received for IBM - $130 it cost you to buy the stock - $10 it cost you to buy the option).      

The lure of options and futures to a lot of investors is that they allow for a lot of leverage.  Leverage means that you can control a lot more assets than you have cash.   For instance, there is a contract traded on the Chicago Board of Trade called the Dow-mini (this is a futures contract).  The value of the contract is $5 times the value of the Dow, or about $57,500 as I write this.  However, to buy this contract, you only need to put up $3,125 in margin.  Now if the Dow goes up 100 points, you make $500 on a $3,125.  $500 on $3,125 is about 16% return on investment, on what was about a 0.87% move in the index (100/11500).  However, if the dow goes down 100 points, you lose $500 on your $3,125 investment, or 16%.  Worse, you losses aren't limited to the amount you put up.  If the dow drops 1,000 points, you lost $5,000.  Not only do you not get any of your $3,125 back, your broker sends you a bill for the other $1,875 you lost.  More likely, they'll sell you out when your account gets close to zero (and they have a right to do this to protect themselves).  



Options...same thing.  People look at trading options as a road to high quick returns.  If you buy an option, and get it right, you can double your money...easily.  Get it wrong, and you lose everything you invested.  For instance, buying an option on IBM Aug 130 costs about $3 now.  If you believe that IBM is going to 140, and you buy 100 shares, you invest $13,000.  If it goes to $140, you get back $14,000, or about a 7.7% return on your money.  However, if you buy an option on 100 shares, it costs you $3, or $300.  If you are right, you buy the stock and sell the share (or more likely, just sell the option), and net $10/share ($1,000), for a profit of 233%.  However, if the stock stays at $130, whereas the person who bought the stock is even, the person who bought the option loses everything because the option expires.  If the stock goes to $132, the stock buyer makes about 1.5%, while the option buyer loses 33%.  

Retail (small) investors often get into options and futures with dreams of easy money and huge returns.  They aren't satisfied with "slow" growth in long term investments and are looking for easy money.  They usually end up wiping out their accounts.  Most professional traders have wiped out one or more accounts on the way to figuring out what they were doing.  If you are really going to go down the trading road, be prepared to work at it for a while before you begin to see results, and plan on losing money at first.  Like any other skill, it must be learned, and you will make mistakes at first.