Futures and options are not for the faint hearted!
They are sophisticated investments that should not be undertaken casually. Investors whose experience is limited to less volatile, less leveraged and less risky vehicles like stocks or bonds should be aware that options and futures markets require a much stronger stomach for risk!
Yet, if you've got a strong stomach for risk, options can provide a helpful hedge to protect yourself from dips in stocks or indexes you already own, while futures, in small amounts, can offer an alternative form of portfolio diversification.
On the other hand, you have to realize that futures and options are not for lazy investors. Unlike stocks, which can be purchased and held for years, options and futures are time-based assets with deadlines for action.
A derivative is a financial instrument that does not constitute ownership, but a promise to convey ownership. Examples are options and futures. The most simple example is a call option on a stock.
An option is a derivative. That is, its value is derived from something else. In the case of a stock option, its value is based on the underlying stock. In the case of an index option, its value is based on the underlying index.
A futures contract is an agreement to buy or sell some commodity at a fixed price on a fixed date.
Options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright.
Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing options, to earn premium income.
A major advantage of options is their versatility!
They can be as conservative or as speculative as your investing strategy dictates. Options enable you to tailor your position to your own set of circumstances.
Consider the following benefits of options:
You can protect stock holdings from a decline in market price.
You can increase income against current stock holding.
You can prepare to buy a stock at a lower price.
You can position yourself for a big market move even when you don' t know which way prices will move.
You can benefit from a stock price rise without incurring the cost of buying the stock outright.