Futures and options belong at the high-octane end of the investment market.
They are a sophisticated and potentially risky way of betting on the price
movement of anything from shares to commodities. Options can be granted over
many assets, including bonds and commodities, but the one most widely used
by retail investors are share options.
Options come in two basic types - calls and puts - and you pay a price for
taking them out. Calls give you the right, but not the obligation, to buy a
share at a fixed price in the future - the option price. With calls,
essentially you are betting that the price of a share will rise above your
option price, or strike price, so you would be able to acquire the share at
the lower option price and then sell it in the open market at the prevailing
higher price.
You start to make a profit when the open-market share price is greater than
the combined value of the option purchase price and the original cost of
your call option.
With a put, you are betting that a share price will go down, so you will be
able to acquire the share at the lower open-market price and then sell at
the higher option price. You will start making a profit when the market
price falls sufficiently low that the cost of buying a share, plus the cost
of the original put option, is still lower than the option sale price.
As the share price moves up and down, so does the put or call option. In the
case of a call option, an upward movement in the share price usually
triggers a similar upward movement in the option price. With puts, the
option price rises as the share price falls.
The pricing of options can be confusing to new investors, so it may be helpful
to consider an example. Take an imaginary company, XYZ Engineering, the
share price of which currently stands at 250p. Suppose you buy a call
option, costing 20p a share and expiring in May, which allows you to buy XYZ
Engineering shares at 240p. Essentially, this means that the share price
would have to rise above 260p before you started to see a profit, because
you have paid 20p a share for the option and will have to pay 240p for each
XYZ share if you exercise that option.
If, by the end of May, the share price has not exceeded 260p, then you will be
unable to exercise your option at a profit. If you let the option lapse,
your loss will be the 20p-a-share cost of the original option. If you took
an option for 1,000 shares, your loss would be £200.
Conversely, if the share price shot up to 280p in April, you would be able to
exercise your call option at a profit of 20p a share, so that an option on
1,000 shares would net you £200. But you probably would not have to go
through the option exercise process. While the XYZ share price was rising,
so too would be the price of your call option. If it rose to 40p, as it may
well do, then you could simply sell your call option and make a profit of
20p an option, or 100 per cent on your original investment.
John Prior, of Killik & Co, the stockbroker, adds that there is a grey
area between 240p and 260p where it is still worth exercising your option
even though you will not make a profit. “You will make something on the
exercise process to offset the original 20p cost of the option,” he says.
“For example, if the share price is 245p, you will have made 5p by
exercising your option to buy at 240p and then selling at 245p, and this
will reduce your potential 20p loss to 15p.”
In most cases, investors do not actually exercise the option at the end of the
specified period - they either sell the option at a profit before the
exercise date if the price has gone the right way, or they allow the option
to lapse if it has not.
The attractions of buying put or call options are evident from the above
example. If the share price goes the wrong way, your potential loss is
limited to the cost of the option. But if the share price goes in the right
direction, there is no limit to your potential profit. Another attractive
element is the potential gearing effect that options offer. Because the
price of an option is only a fraction of the related share price, a small
movement in the latter can trigger a large movement in the option price. You
can also make money in both falling and rising markets.
Futures work in a similar, but not identical, way to options. The principle is
the same - you are betting on the future price movement of an asset. As with
options, you can make money whether markets rise or fall. Futures can
involve individual shares but also cover other types of assets, including
bonds, interest rates and a range of products and commodities - you really
can buy Chicago pork bellies if you want.
A future is an agreement to buy or sell a given quantity of a particular asset
- barley, oats, oil - at a specified future date at a pre-agreed price. You
can open a futures position by either buying or selling a future. You can
later close your futures position by doing the opposite - either selling or
buying the same future.
If you are bullish about an asset, you would buy futures - known as taking a
long position. So if you thought that the price of soybeans was set to rise,
you would buy soybean futures and have a long position in soybeans, hoping
to sell at a higher price later on. If you are bearish about copper, you
would sell copper futures and be short in copper, hoping to buy at a lower
price later on.
If you hold your futures contract right up to the delivery date, then you
would, if long in the asset, receive settlement, whether in cash or by
taking physical delivery of the asset. For example, with bonds you would
receive a bond certificate, while for FTSE index futures you would receive
cash. If you are short in the asset, you would have to deliver the stated
amount to the designated buyer or provide the equivalent cash value. Most
people close their futures positions before the delivery date.
Cambridge folklore has it that in the 1930s J.M. Keynes, the celebrated
economist, was once caught holding a long position in wheat that he could
not readily close and was rumoured to have eyed up King's College chapel as
a possible storage space.
Mr Prior says: “Futures and options are for sophisticated investors only, as
both are complicated and risky - especially futures, where potential losses
are not limited to your original investment.”
