If considering a wider investment strategy than simply investing in a portfolio of stocks and share, one consideration is an investment in so called vanilla derivatives such as options and futures. Such derivatives are available from a variety of specialist futures brokers, stock brokers and online trading platforms.
How does Futures Trading Work?
A futures contract represents a promise on the behalf of the investor to purchase a fixed quantity of a commodity on a future date at a given price, this price is know as the strike price. However, in most cases the contract will be settled in cash, rather than the buyer taking physical delivery of the commodity.
Assuming that the price of the commodity has fluctuated from the initial strike price, this will determine the profit or loss to be made by the investor. If the price of the commodity has risen, the investor will be able to buy the commodity at the strike price and then sell the commodity on at the higher market rate, thus making a profit.
If the price of the commodity has fallen below that of the strike price, then the investor will still have the obligation to buy the commodity. However, the commodity will then be sold on at a discount in comparison to the strike price, thus representing a loss for the investor.
How does Options Trading Work?
Options are a similar derivative to futures contracts however, the key difference is that an option gives the investor the right to buy a commodity at the strike price in the future, but not the obligation. For the right to exercise such an option at a future date, the investor will pay a premium or fee to the writer of the option.
Should the price of a commodity rise above that of the strike price, then the investor will exercise their option to buy the commodity. As such, a profit will be made by buying the commodity at a discount and selling it on at the market rate.
Should the price of the commodity fall below that of the strike price, then the investor is under no obligation to exercise the option. As such, the investor will walk away from the option and thus the loss is limited to that of the premium paid.
In summary one can see that investing in basic vanilla derivatives such as futures and options is a way to gain a wider exposure to a greater number of assets than trading in stocks and share alone. However, the short term and definitive nature of futures and options means that such trading may not be appropriate for the long term investor.
Sources:
- Arnold, G. 2004. The financial times guide to investing. Harlow: FT Prentice Hall.
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Frank Smith - Frank Smith currently works as an full time industry analyst for a well known construction company in Lincolnshire. In his spare time, ...
