Options and Futures

When it comes to options and futures, not too many people have the knowledge it takes to trade them. Most folks prefer more popular investing opportunities such as real estate or the stock market, simply because they’re familiar with these types of investment asset classes (or at least they think they are.) But outside of this mainstream, there’s a smaller part of the population who does understand the nuts and bolts of options and futures trading, and know exactly well the exciting financial opportunities they offer. And while there are always elements of risk to consider with options, the knowledgeable investor will be in a better position to substantially limit these risks.

Overall, options are relatively new. They began trading publicly in 1973 in the stock market, and only since the early 1980s on regulated futures exchanges. As an investment, they could be considered highly speculative or highly conservative. It all depends on your objectives.

On the speculative side, you may be buying or selling options in anticipation of a market price move you think will go your way. You may stand to earn a large profit with one option. Or, it’s possible that even with a few profitable options you could more than make up for losses incurred on other options that didn’t quite go your way. In contrast, on the conservative side, you may be trading options as an ‘insurance’ or protection against a possible loss from a futures contract you’re holding. In this case, you’re using it to hedge a risk position.

And in between these two extremes of speculation and conservatism, there’s a whole range of possibilities that exist for trading options and futures. They’re all based on different strategies and techniques you may employ, designed to increase your profit potential and/or limit your risk exposure.

People trade options for different reasons. As you’ll soon learn, there are call options and put options, and you can either buy them or sell them. Therefore, options allow you to profit no matter what your outview of the market at the time may be. You might trade options because you’re bullish about the market, but want to limit your risk, or you’re bearish and want to limit your risk. Or you might trade options because you think there’s going to be a large price move, upward or downward. Then again, you might even trade options because you believe that there won’t be a price move at all! All of these scenarios are possible, and any one of them can make you money.

So as you can see, trading options offers enormous flexibility. This is one of their main attractions. They are, by far, much more flexible than simply trading stocks and futures contracts with traditional methods.

In addition to their flexibility, options – whether you’re buying or selling them – have some other extremely appealing aspects:

a) they offer the option buyer the potential for earning unlimited profits while limiting the risks to only the up-front cost of the option (known as a premium) plus transaction and commissions costs;

b) they offer the seller of an option extraordinary probabilities of profits by putting the odds heavily in their favor;

c) last but not least, they offer the option trader an incredible amount of leverage. As the owner of an option on a certain ‘asset’, you control that asset – which is worth a great deal of money – for only a fraction of its cost. In other words, you put up a premium, which is a small amount of money in relation to the value of the asset you’re going to control. In turn, this asset has unlimited profit potential. What this means to you, is that because you have so little capital tied up, your returns on this investment are enormous. Also, since you don’t need to tie up a lot of money to buy the asset itself, you could instead put this money to work in some other investment. And on top of it all, you can limit your risk to just the little money that you tied up. Indeed, this is what you call a pre-defined risk.

The subject of options can be fairly complex. My greatest challenge with this tutorial is to communicate these complicated concepts by explaining them in the simplest way so it makes sense to everyone. But most importantly, by explaining things in a way that will give you immediate useful application. If this tutorial were about automobiles, I would have started by first explaining the benefits of owning one. Then, go on to explain some basic parts of the automobile, such as the steering wheel, the breaks, review mirror, etc., giving you examples of how you would use them. Then I’d take it one step further, and begin to describe some of the more technical aspects of an automobile, such as the internal combustion process, and give you a more sophisticated understanding of what keeps a car running. Finally, I would show you what you’ve been waiting for all along, which is how to drive and get the best use out of your car. 

You’ll find this tutorial to be very similar to this automobile example. I'll begin by introducing you to the jargon of options and how it all works together. We’ll continually be reinforcing these concepts with simple examples you can follow. As you become comfortable with options theory and the language of options, I'll begin covering in more detail the mechanics of trading and show you how to read and interpret option prices for all of the main futures markets. But I feel that, by far, what you’ll enjoy the most from this tutorial, will be learning some of the best strategies and combined techniques used for trading options. These techniques are designed not only to make you money, but also to make it the safest possible way.

One final observation before we begin: you can buy or sell options on different type of investments classes, most commonly the stock market or futures contracts. The process is identical whether it's stocks or commodity futures, but we’re going to stick throughout this tutorial with options on futures. Our examples will usually refer to the futures markets, which is where our interest lay.

Next: go to What Are Options to start the tutorial.